Hey, Janet, How’s That Interest Rate Increase Working Out?

I finally understand the thinking behind the Fed’s activities trying to raise interest rates.  Prof. Ray Fair (Yale) was kind enough to explain this in words of one syllable.  The Fed believes that raising interest rates paid on reserves will induce banks to sell Treasury securities so they will have more reserves.  Treasury security prices fall, interest rates rise, voila.

Utter nonsense.  I once respected the Fed’s economists.  No more.  Here’s why.

The Fed is assuming the banks will sell Treasury securities.  Why?  There are many other assets banks can sell if they want to increase their reserve deposits.  In principle, those asset sales should push up interest rates.  While I could draw a link between CDO prices and market interest rates, that seems kind of pointless.

But the real problem is that the Fed has not understood why banks are holding all those reserves.  There are two reasons.  First, there is incredible risk aversion caused by the random, frequent regulations and lawsuits emanating from the Obama administration.  Second, there is the small matter of loan demand.  Banks are holding reserves because they don’t see demand for loans whose return is worth the risk.  The only way loan demand will increase is for the economy to ascend to a decent growth rate.  Until that happens, the Fed should just give up.

For those looking for evidence, I offer the Treasury yield curve between December 17, 2015 and January 14, 2016.  Sure doesn’t look like interest rates are rising.

Treasury Yield Curves

Monetary Policy as a Confidence Game

The Board Of Governors The Forever ZIRP

The Board Of Governors: Chair Janet Yellen, Vice-Chairman Stanley Fischer, Jerome H. Powell, Daniel K. Tarullo, Lael Brainard

Tomorrow the Federal Reserve (Fed) is expected to announce that they will raise interest rates for the first time in eight years. Dr. Janet Yellen, the Chair of the Board of Governors, studied at Yale under Prof. James Tobin, one of the most outstanding monetary theorists in history. She has had it drummed into her head that raising interest rates is contractionary and lowering rates is expansionary. The only explanation I can think of is signaling. By raising interest rates the Fed believes they can send a signal to markets about the Fed’s confidence in the economic recovery. In other words, the Fed is playing monetary policy as a confidence game.

Will it work? I’m skeptical that the Fed can even manage to raise the Federal Funds rate. For my reasoning, read on.

M1, M2, Reserves, Oh My

A few months back I wrote about the arcane topic of the relationship between monetary aggregates (M1, M2) and bank reserves. At the end of December 2014, excess reserves were about 95 percent of total reserves. The Federal Reserve (Fed) was holding $2.66 trillion in total reserves, but required reserves were $142 billion.

Most Fed-watchers believe the Fed will announce an interest rate increase at the conclusion of the current Federal Open Market Committee (FOMC) meeting tomorrow. The question I want to explore is how they will manage to accomplish that goal.

Background: Federal Funds, Reserves, and the Fed

Since about 1975 the Fed’s monetary policy target variable has been the Federal Funds rate.[1] There’s nothing mysterious about this interest rate. It is the rate banks charge each other for 24 hour lending and borrowing of bank reserves. The historic reason for these activities has been reserve requirements. Banks are required to hold a minimum percentage of their deposits as reserves. Reserves include vault cash and deposits at the Fed.[2] Vault cash is just currency held by the bank.[3] Deposits at the Fed are called bank reserves.

Again historically, when the Fed has wanted to raise the Federal Funds rate they engaged in an open-market sale of government securities. The result of this transaction is that the private sector ends up holding more securities and the Fed holds more deposits. Deposits held by the banking system have decreased. So have required reserves.[4] Banks will reduce their reserve holdings. And a lower quantity of reserves reduces supply in the Federal Funds market, pushing up interest rates. When the Fed wants to lower interest rates they engage in an open market purchase of government securities, increasing bank reserves.

The point of all this is that the Fed actually relies on the market mechanism – supply of and demand for reserves – to hit interest rate targets.

Brave New Monetary World

Today banks have $2.5 trillion in excess reserves. I sometimes marvel at the fact that there is any demand in the Federal Funds market at all. But there apparently is. The Fed will raise their target for the Federal Funds rate. That will induce … what? Banks will want to lend more of their excess reserves to other banks, but the higher interest rate will reduce quantity demanded. The outcome is unpredictable. But I will hazard a guess that the Fed will discover they can’t actually raise the Fed Funds rate.

I know there are some smart people on the Board of Governors. I have the highest respect for Dr. Stan Fischer. Some of his work was the inspiration for my Ph.D. dissertation. But honestly I am not sure they have thought this through.

There is one other possibility: they might raise the discount rate, the interest rate the Fed charges banks for borrowing from the Fed. That would be consistent with the hypothesis that all this is mainly propaganda.

Global Markets Matter

One factor overlooked by many people is the large disparity between U.S. interest rates and similar rates in other countries. I wrote about this recently and won’t repeat the story here. But I will say that markets expect a serious U.S. dollar depreciation over the next ten years. If that happens, the effect may well be to put downward pressure on U.S. interest rates. There is considerable uncertainty about this because of the role of expected future exchange rates in uncovered interest parity. I may do some research and add another note later this week.

The Fed as Proselytizer[5]

Any objective look at the U.S. economy will tell you that the best word to describe the current recovery is “troubled.” People continue to flee the labor force. That decrease in the number of people either employed or looking for work has mainly been caused by a decrease in the labor force, the sum of those two totals. The percentage of people with part-time jobs who would like a full-time job is reaching all-time highs. Inflation remains barely detectable. Indeed, just this morning I heard a not-very-bright observer comment that inflation has been low because of declining oil prices. You may recall that decades ago the Fed created the “core CPI” which excluded the “volatile” prices of food and energy. Apparently now that energy prices are falling, they have begun watching the overall CPI again. Which is, of course, nothing more than cherry-picking the economic indicator that most justifies what you plan to do anyway.

So why raise interest rates? Dr. Janet Yellen studied at Yale under Prof. James Tobin, one of the most outstanding monetary theorists in history. She has had it drummed into her head that raising interest rates is contractionary and lowering rates is expansionary. The only explanation I can think of is signaling. By raising interest rates the Fed believes they can send a signal to markets about the Fed’s confidence in the economic recovery. The Fed is playing a monetary policy confidence game.

Will it work? Tell you what – first let’s see what the FOMC actually announces. If they just raise the discount rate it’s pure public relations. If they announce a higher target for the Fed Funds rate, then we get to see if they can actually pull it off. Either way, the next week or so should be entertaining.

Update on M1, M2, and Bank Reserves

I know that both my faithful readers would be disappointed if I didn’t include some numbers in this treatise. But it doesn’t matter because nothing much has changed. At the end of November, 2015, total bank reserves were $2.66 trillion. Of that, $0.15 trillion are required reserves, leaving $2.15 trillion in excess reserves, 94.44% of the total. The only glimmer of good news is that totals have not changed much since the beginning of 2014. As always my methods are transparent. Click here to download the Excel workbook with the underlying figures and my calculations.


“May you live in interesting times.” When I was studying monetary theory in graduate school I never imagined this old Chinese curse would apply to the mundane field of monetary policy.

[1] The best-known exception to this general rule is from 1979-1981 when Paul Volcker changed the focus to the growth rate of the money supply. Mr. Volcker retains his hero status to many of us for knowing how to kill off inflation.

[2] Yes, I know it’s more complicated than this. For current purposes I only need a simple model.

[3] I have long believed that it’s called “vault cash” as a constant reminder to bankers about where they should keep currency. Put it in the vault. Don’t leave piles of Federal Reserve notes lying around on the counters. Sound banking practices are sometimes very simple.

[4] If you don’t like this story, try the case where the Fed sells securities directly to banks. The banks pay for those securities with reserves, reducing the quantity of reserves directly.

[5] Look it up.

I Was Wrong About ZIRP

Slim Pickens' finest cinematic moment i was wrong about zirp

Slim Pickens’ finest cinematic moment (click for larger image)

A few months ago, I argued that the Fed’s zero-interest-rate policy (ZIRP) would last forever.  Today I admit I was wrong about ZIRP.

Although negative rates have a “Dr. Strangelove” feel, pushing rates into negative territory works in many ways just like a regular decline in interest rates that we’re all used to, said Miles Kimball, an economics professor at the University of Michigan and an advocate of negative rates.

Not, mind you, because the Fed will raise interest rates any time soon.  No, the geniuses at the Federal Open Market Committee and the Board of Governors seem to be leaning in a different direction: NIRP.

Better get used to seeing those initials.  They stand for negative-interest-rate policy.  That’s right.  The Fed thinks they can drive nominal short-term interest rates below zero.

For a good discussion of the Fed’s likely direction and its implications, see Greg Robb’s piece on Marketwatch.com. Greg gets it right here →→→→→→→→→→→→→→→→→→↑

We’ve Seen Negative Yields Before

Now it happens that there is a Treasury security that has paid negative interest rates off and on over the last couple of years: TIPS.  That’s Treasury inflation-protected securities.  These securities pay a real interest rate.  So when their yield is negative it simply means markets expect future inflation to be higher than current nominal interest rates.  (Remember the Fisher equation: r = i pe where r is the real rate of return on a security, i is the nominal return as usually quoted, and pe is expected future inflation over the life of the security.)

But negative nominal yields are a different kettle of fish.  Positive nominal yields mean borrowers are paying lenders to lend them money.  Negative nominal yields mean lenders are being asked to pay borrowers for the privilege of lending them money.  Most of the time that is insane.

Would NIRP Work? No.

And it would not make any difference.  The Fed has been flooding markets with liquidity for five years.  Virtually the entire tsunami has ended up being held as bank excess reserves at the Fed.  Why will more liquidity lead to a different result?  As I’ve argued in the past, monetary policy has done all it can to solve this crisisThings will not improve until (if?) a new president takes office and begins to undo some of the regulatory mayhem that the current administration has wreaked on the U.S. economy.

My guess is that the Fed thinks they can do this because there has been a global flight to safety.  And safety is still good old U.S. government Treasury securities.  Whether global markets want safety so much that they are willing to pay a premium to get it remains to be seen.  I, for one, am skeptical.  New Zealand, Australia, South Africa, Chile, the U.K., Norway, and Canada all have pretty safe government securities.  I predict the Fed will soon discover another result of globalization.


I learned a lot of what I write when I took monetary theory in graduate school. Prof. Karen Johnson (later my dissertation adviser), fresh out of M.I.T., inspired much of my thinking.  (I hardly have to add that Dr. Johnson is in no way responsible for my ramblings here.)  She understood both the theory (complete with heavy-duty math) and the practical aspects of monetary policy.  Sadly, I fear that institutional knowledge that I took for granted has been lost.

Advent of the Southern Euro

Drachma and Euro

Drachma and Euro

[Update 2 June 30, 2015, 1:35 pm with comment and image via Neil Wilson (@neilwilson).]

[Updated June 30, 2015 1:20 pm left-coast time GMT -8 with two new comments from joao.]

In his near-future novel Supersad True Love Story (Random House, 2011) Gary Shteyngart introduced the idea of a “northern euro” and a “southern euro.” Mr. Shteyngart has been correct on so many issues that he may need to update his resumé, changing his job description from “writer” to “futurist.”

Today saw another potential step in this progression. There is speculation that Greece will leave the euro zone but still use the euro as currency.

What Is Money?

Money is anything that is widely accepted in exchange for goods and services in ordinary commercial transactions.

It’s important to have a good, working definition of “money.” One of my graduate fields was in monetary theory and I’ve taught money and banking many times. Here’s the definition I use →

For Greece, the relevant part of the definition is “widely accepted.” A Greek euro is not money outside Greece. That means the Greek euro is, de facto, a separate currency. Greece might as well just go back to the drachma. (Indeed, Twitter user joao called the currency the “euro-drachma.”)

Is Greece Blackmailing the ECB?

Via Neil Wilson on Twitter:

Some sort of font failure makes the Greece debt restructuring request look like a ransom note


Font Failure

(click image for larger version)

How Will the Euro-Drachma Be Implemented?

To understand this you need to understand how interbank settlements work in the eurozone. Let’s start with the definition of “interbank settlements.” Let’s say you want to buy something at a store that banks with Wells Fargo.[1] You bank with Citibank. You use your debit card to buy something in the store. The interbank settlement system is the mechanism that moves funds from your Citibank account to the store’s Wells Fargo account. In the U.S., most large banks are members of the Federal Reserve system which handles interbank settlements. In the eurozone, it’s the European Central Bank. Here’s the description from the ECB website:

TARGET2 is the real-time gross settlement (RTGS) system owned and operated by the Eurosystem. TARGET stands for Trans-European Automated Real-time Gross settlement Express Transfer system.

The speculation about creation of a euro-drachma began with this tweet from Megan McArdle (@asymmetricinfo):[2]

I don’t think ECB will force Greece out of euro; I think it will have to devalue if it wants to reopen its banks ever.

Which, of course, led me to ask how Greece could devalue the euro vis-à-vis the euro. An answer was supplied by joao (@mar67760521):[3]

Yes, TARGET2 shutdown by the ECB will mean Greece has €-dramchas type of currency, not yet though

Yes, TARGET2 shutdown by the ECB will mean Greece has €-dramchas type of currency, not yet though

No, Greece will still use the € but can’t get the money out of Greece. TARGET2 gets shutdown.

So, effectively, Greece will have its own euro. (Interestingly, the ECB did much the same thing with Cyprus a few years ago.)

Joao was kind enough to supply some additional input (and a valuable web link). I have concatenated tweets per the “+” sign in the originals.

ECB has put a cap on TARGET2, as of this moment, it is in effect because Bank of Greece choose too obey ECB. There is nothing that says BoG has to obey the ECB and if the ECB decides to shutsdown TARGET2 for good, it will mean that BoG is now independent. It can still print €’s without ECB consent.

So there you have it.  The decision rests with Greece.  I doubt very strongly that the Greek central bank will actually print euros.  But, from a purely academic viewpoint, it would make for an, um, interesting situation.

For an interesting and mildly entertaining analysis, see Greece and the Art of Liquidity.

Will This Work?


The ECB Weighs In

Les Echos interviewed Benoît Cœuré, Member of the Executive Board of the ECB. The interview was published on the ECB website on June 29.

Interview with Les Echo

Interview with Benoît Cœuré, Member of the Executive Board of the ECB, conducted by Nicolas Barré, Catherine Chatignoux, Jean-Philippe Lacour, Etienne Lefebvre, Guillaume Maujean, Dominique Seux and François Vidal, Les Echos, on 29 June 2015.

Is Greece’s exit from the euro area now the most probable hypothesis?

Greece exiting the euro area, which used to be theoretical, can unfortunately no longer be ruled out. It’s the result of the Greek government choosing to end discussions with its creditors and resorting to a referendum, causing the Eurogroup not to prolong the second adjustment programme.

The ECB, like the other European authorities, wishes Greece to stay in the euro area. That’s the substance of the proposal made last week by the Commission, the IMF and the ECB in the form of a programme of reforms and a financing offer that is much more favourable than anything proposed in the past. Europe has never abandoned Greece.

In what way were these proposals more favourable?

They gave Greece the time and the freedom to reform its economy, for example its labour market, while envisaging a demanding budgetary path, but taking account of the deteriorating economic climate. The primary surplus requested was reduced to 1% of GDP in 2015, compared with 3% previously. We were also proposing larger cuts in military spending to create room for manœuvre elsewhere.

So does the responsibility for breaking off talks lie entirely with Greece?

The decision to interrupt discussions was taken by the Greek authorities. That also surprised us, for we were coming to the end of some quite focused and fruitful exchanges.


At this point, I am mystified as to why the Greeks want to stay in the eurozone. Now that they’ve been locked out of the interbank settlement system, there’s very little advantage to be gained from continuing on that path. Bring back the drachma!

[1] Banks named are for example purposes only. This does not imply any endorsement.

[2] In all tweets I have removed the Twitter handles of those mentioned in the message. If you’re curious you can follow the links to see the original tweet.

[3] joao is probably located in Brazil. Roughly translated “joao” is “John.” Search for “Joao de Deos”

Bitcoin in Argentina

There’s a new book on the history of Bitcoin. Digital Gold by Nathaniel Popper covers the history and implications of the world’s most popular crypto-currency (Harper, $27.99, $19.01 at Amazon.com). While perusing the review in today’s Wall Street Journal I noticed something interesting. The country that uses Bitcoin the most is Argentina.[1]

Argentine Peso coin and notes Bitcoin in Argentina

Argentine Peso coin and notes

I thought perhaps I had stumbled on to a new idea. I was mistaken. The Economist and the New York Times have written about Bitcoin in Argentina during the past year (more or less). This article will first review the data. Next, I’ll excerpt the two articles from the media. As always, my data is transparent. Click here to download the Excel workbook.

Stylistic Note

Throughout this article I will use Bitcoin and bitcoin. Bitcoin refers to the name of the currency operation and its various adherents. By contrast, bitcoin means the currency itself. I know that’s confusing but it seems to be the stylistic convention in the media.

Argentina’s Recent Monetary History

Argentinians should be concerned. Here’s what has happened to the peso vis-à-vis the dollar over the past five years:

Dollars Per Peso Bitcoin in Argentina

(click for larger image)

You’re reading that correctly. On June 10, 2010 one peso would buy $0.2544. On June 10, 2015 that same peso would buy $0.1106. That’s a 56.52% depreciation vis-à-vis the dollar, or 10.78% per year (compounded).

It turns out that Oanda.com uses the official exchange rate. Over at the Cato Institute’s Troubled Currencies Project,[2] Prof. Steve Hanke lists Argentina at number six on his currencies watch list as of January 1, 2015. Argentina has sporadically been on the list of troubled currencies. Prof. Hanke has an archive of previous list members (near the bottom of the Troubled Currencies page). He includes his estimate of the black market exchange rate. The charts below show the official and black market exchange rates as well as the official inflation rate and the inflation rate implied by the black market exchange rates. (Note that the vertical scale in the exchange rate chart is inverted, running from high to low.  To make the charts comparable, my exchange rate chart above also inverts the vertical axis.)

Argentina Exchange Rate Black Market Bitcoin in Argentina

(Click for larger image)


Argentina Inflation Bitcoin in Argentina

(click for larger image)

The annual depreciation of the peso using the black market exchange rate is 28.55% per year. And Prof. Hanke’s estimate of annualized inflation has been, with a very few exceptions, in double-digits since January, 2013. The high was over 100% per year in mid-2013, with other peaks of 70% in February and October, 2014.

Argentina’s economy, especially the monetary sector, is in big trouble.

The Economist Weighs In (June 12, 2014)

Almost exactly one year ago, The Economist ran a story on the seemingly natural fit between Argentina (with its troubled monetary sector) and Bitcoin (currency with apparently no borders). The article explored the reasons for Bitcoin not taking hold faster. Here’s how the magazine describes the fit between the two:

ARGENTINA and Bitcoin would appear to be a match made in heaven. On the one side stands a country which since the second world war has suffered numerous bouts of inflation, and even hyperinflation–rising to as high as 20,000% in the late 1980s (see our recent briefing on the country). Things are better these days, but inflation is still expected to hit 38% by the end of the year.

On the other is a crypto-currency, backed by cold mathematics rather than a populist government. It is meant to provide protection against inflation. And it allows getting around the cepo, the set of legal restrictions put in place to prevent money from leaving the country. Legal purchase of dollars, for instance, is subject to fixed monthly limits at the exchange rate set by the government (usually 30-40% less than the black market rate). Credit-card transactions made outside Argentina incur a 35% surcharge.

The article goes on to explain that only 130 brick-and-mortar businesses accept Bitcoin.[3] The Argentina Bitcoin Foundation claimed between 15,000 and 20,000 Argentinians held bitcoins. The Economist identifies two main reasons Bitcoin has not taken off in Argentina:

  1. Using bitcoins for transactions still takes some fairly high level computer skills. As economists would put it, Argentina is relatively scarce in that factor of production.
  2. Obtaining bitcoins can’t be done through Argentina’s banking system. A resident must have access to a foreign bank account.

The second problem actually appears to be an opportunity. Look at this map. The red arrow points to Buenos Aires, just across an inlet from Uruguay. Argentina also borders Brazil, Paraguay, Bolivia, and Chile. Some informal cross-border trade in banking services may be occurring. (If it’s not there is an entrepreneurial opportunity here for bankers in those countries. One additional complication: while the border between Argentina and Chile is very long, it appears to follow the crest of a mountain range.)

Argentina Map Bitcoin in Argentina

(click for larger version)

Yet the best indicator may be that the country’s central bank seems to be getting nervous. On May 27th it issued a statement discouraging the use of virtual currencies. These¸ the bank said, are not backed by the government, and are subject to wild fluctuations in price, among other terrors. It warned that “the risks associated with transactions involving the purchase or use of virtual coins as payment, are supported exclusively by their users.”

Nevertheless, even in 2014 there were signs the government was getting nervous. Again from The Economist →

When the central bankers are getting nervous you must be doing something right.

The last section of this article discusses more recent data.  Bitcoin is becoming more accepted.  One innovative startup has introduced bitcoins as an intermediate currency in foreign exchange transactions. Another uses prepaid cell phones for Bitcoin transactions, allowing technologically unsophisticated users easier access to the system — and also limiting government monitoring.

Added note: The Economist ran a long white paper about Argentina in the February 15, 2014 issue. This is highly recommended for anyone wanting more background.

An Update From The New York Times (April 29, 2015)

Ten months later the New York Times published “Can Bitcoin Conquer Argentina?” (This is actually an excerpt from Digital Gold by Nathaniel Popper mentioned at the beginning of this article.) Despite the hyped headline, the article is really more of a sales pitch for Bitcoin. Nevertheless, parts are instructive. Unfortunately, the article is long on anecdotes and stories while being woefully short on actual data about Bitcoin use.

The story begins by describing a day in the life of Dante Castiglione, a black-market money trader. But his product is differentiated from others who simply accept pesos in exchange for hard currency (usually the good old U.S. dollar). Mr. Castiglione buys and sells bitcoins, often in exchange for U.S. dollars. This is, of course, the usual practice in countries with rapidly depreciating currencies and rampant inflation: a “hard” currency operates as a medium of exchange in parallel with the local currency. Bitcoins are not a medium of exchange because they are not widely accepted for goods and services. But they do have a market value and can be used to buy dollars, the hard currency in Argentina.

And bitcoins have several advantages over services like Paypal. There are no transaction fees. Transferring bitcoins to another member of the network is easy and fast. And, importantly, transaction records are not widely available.

The Times article includes this instructive case study:

In contrast, the best-known Bitcoin start-up in Argentina, BitPagos, is helping more than 200 hotels, both cheap and boutique, take credit-card payments from foreign tourists. The money brought to Argentina using Bitcoin circumvents the onerous government restrictions on receiving money from abroad. Castiglione has some hotel clients, but he says that many of his 800 or so registered customers are freelancers who use Bitcoin to get paid by overseas clients, or companies that want to move money in and out of Argentina. A popular new online retailer, Avalancha, began accepting Bitcoin last summer and has seen the volume of Bitcoin transactions grow steadily since then. Avalancha offers customers a 10 percent discount when they use the virtual currency, because accepting credit cards generally ends up costing Avalancha more than 10 percent as a result of the vagaries of the Argentine financial system. The Bitcoin community in Buenos Aires has been vibrant enough to produce what’s known as the Bitcoin Embassy in the center of the city, a four-story building that serves as the home to eight start-ups whose businesses depends on the Bitcoin network.

But, if you read long enough you’ll discover the story of Brenda Fernández.

One of Castiglione’s main competitors was another Bitcoin broker named Brenda Fernández. Originally from the Buenos Aires suburbs and a college dropout, she previously smuggled electronics into the country and sold them on the local equivalent of eBay. She talked in loud bursts, punctuated with high-pitched laughs, and proudly made provocative statements about breaking the law and ignoring standard business practices when I met her at an event at the Bitcoin Embassy. “I find a way to market myself as the crazy Bitcoin girl,” she told me.

[The author returns to Buenos Aires in February, 2015 after his first trip in June, 2014.]

Earlier that day, as I sat with Fernández in a Subway sandwich shop, which was her temporary office, chosen for its free Wi-Fi, she did not try to hide her difficulty in adapting to the more competitive environment with her “crazy Bitcoin girl” routine, which was making it hard to keep big customers. She did have one business in the United States that sent her about $5,000 worth of Bitcoins each month and had her exchange the money and deposit the pesos into the company’s Argentine bank account, in order to make payroll. But a lot of her customers were young people who wanted to buy a few hundred pesos worth of a Bitcoin so that they could pay online for a Netflix subscription or a video game. “The market moved in another direction,” she said, “and I didn’t move in that direction.”

Brenda Fernandez Bitcoin in Argentina

Brenda Fernandez (click for larger image)

Apparently some businesses that use Bitcoin are big enough to care about the appearance and demeanor of their black-market currency exchange dealer. This appears to portend well for the future of the crypto-currency in Argentina. Moving into the mainstream is always a good sign.

Hard Data

Hard data is difficult to find for two reasons. First, Bitcoin is a crypto-currency. One of its purposes is to make transactions fairly anonymous. Second, data coming out of Argentina is very unreliable. Even the IMF has made statements about the likelihood of, um, “flawed” national income accounting procedures (emphasis added by me).

The Executive Board of the International Monetary Fund (IMF) met on June 3, 2015 to consider the Managing Director’s report on Argentina’s progress in implementing the third set of specified actions called for by the Executive Board in December 2013 to address the quality of the official data reported to the Fund for the Consumer Price Index (CPI) and Gross Domestic Product (GDP).

The Executive Board recognized the ongoing discussions with the Argentine authorities and their material progress in remedying the inaccurate provision of CPI and GDP statistics since 2013.

However, it determined that Argentina is not yet in full compliance with its obligation under Article VIII, Section 5 with respect to the accurate provision of CPI and GDP data to the Fund. It found that some specified actions called for by end-February 2015 had not yet been completely implemented.

For this reason, the Executive Board decided to extend the ongoing process by one year to give additional time to remedy the provision of inaccurate official data and to undertake an additional set of specified actions. The Managing Director will report to the Executive Board on the status of Argentina’s implementation of the specified actions by July 15, 2016. At that time, the Executive Board will again review this issue, in line with IMF procedures.

There is one website devoted to Bitcoin research. CoinDesk.com offers the following anecdotal evidence about Argentina.

In an article from August 13, 2014, Pete Rizzo reports on a new source for obtaining bitcoins: 8,000 convenience stores:

BitPagos has launched Ripio, a new bitcoin brokerage service that allows consumers in Argentina to buy small amounts of bitcoin at more than 8,000 convenience stores.To achieve this goal, Ripio will integrate with TeleRecargas, a popular mobile phone service that allows consumers to prepay for cell phone plans at a network of partner convenience stores across Argentina.

Argentina and Palo Alto-based bitcoin merchant processor BitPagos raised $600,000 from prominent bitcoin angel investors earlier this year. The company’s CEO Sebastian Serrano told CoinDesk that Ripio aims to target underbanked consumers as well as existing bitcoin users who want an easy way to buy bitcoins at a physical location.

Ripio will use Brazil-based bitcoin exchange Mercado Bitcoin to determine the price at which it sells bitcoin to consumers.

In other words, to avoid government interference consumers will use prepaid cell phones for their transactions. In addition, to maintain a somewhat stable exchange rate, →

The transactions will exchange bitcoins for Brazilian reals. This avoids the ongoing depreciation and instability in the Argentinian peso.

Another pair of startups is using bitcoins as an intermediate currency in foreign exchange transactions. Today the intermediate currency is the U.S. dollar. An intermediate currency is used in foreign exchange transactions between two currencies that have a thin market. Thus if you wanted to buy Argentine pesos with Mexican pesos the companies handling the exchange would buy bitcoins with Mexican pesos then use the bitcoins to buy Argentine pesos.

Bitcoin startups Volabit and SatoshiTango have opened a money transfer service between their respective countries through a collaboration called Coinnect.

Volabit framed the offering as a bitcoin-powered international money bridge for remittances and global commerce that will minimize the bitcoin learning curve.

Bitcoin is hidden from the Coinnect user experience. Those wanting to send money via Coinnect need only deal in their local currencies without worrying about bitcoin’s price volatility.

Finally, OmbuShop, a startup based in Argentina, wants to become the Shopify of South America. Or, for that matter, eBay, Amazon, and every other company that lets merchants set up storefronts. OmbuShop specializes in apparel and accessories. The company claims to have 2,000 merchants.

Bitcoin is making inroads in Argentina. Whether it can eventually become a significant part of the country’s purchasing power remains to be seen.

[1] The Argentine peso, along with Mexico, Hong Kong, Canada, and many other countries, uses $ as its currency symbol.

[2] Steve H. Hanke, The Troubled Currencies Project, Cato Institute – Johns Hopkins University. Retrieved on 6/15/2015 from http://www.cato.org/research/troubled-currencies-project

[3] Remember, this article is one year old.

The Forever ZIRP

ZIRP is the acronym for zero-interest rate policy, currently being followed by many central banks. For better or worse, the central bankers have backed themselves into a corner. My forecast is the forever ZIRP. Read on.


On June 4 the IMF urged the Fed to postpone raising interest rates until 2016. I’ll have more to say about that later in this article. The thrust of this article, however, is a forecast: The Fed’s Board of Governors has backed itself into a corner. They will be forced to keep interest rates at zero virtually forever. This also applies to other major central banks, including the European Central Bank whose gurus recently announced a negative interest rate policy. (Japan has a head start, having implemented ZIRP years before the Fed and ECB caught up.)

IMF Director-General Christine Lagarde The Forever ZIRP

IMF Director-General Christine Lagarde

Who Owns the Bank?

There’s an old saying among bankers: If you have a small loan the bank owns you. But if you have a really, really big loan, you own the bank. Apparently this no longer applies to your friendly local banker. Central banks are now owned by their biggest borrowers: national governments.

The Board Of Governors The Forever ZIRP

The Board Of Governors: Chair Janet Yellen, Vice-Chairman Stanley Fischer, Jerome H. Powell, Daniel K. Tarullo, Lael Brainard

Let’s look at the latest data for the U.S.[1] At the end of 2014 the gross federal government debt was $17.8 trillion. Net interest paid on this debt was $0.23 trillion. The implied interest rate was a whopping 1.29%.

Suppose the Fed raises interest rates by, say, 200 basis points. Assume that increase is passed through to the interest rate paid by the government.[2] The interest rate will be 3.29%. And interest payments on the government debt will become $0.58 trillion.

“So what?” you ask. To put this in perspective the total government budget deficit in 2014 was $0.48 trillion. In other words, a two percentage point increase in the interest rate would double the federal government budget deficit.

And now we can see the real danger of the persistent, large deficits the government has run under the Obama administration. That new debt does not vanish at the end of each year. It accumulates. Effectively, the federal government owns the Federal Reserve.

As always, my methods are transparent.  Click here to download the Excel workbook and play with your assumptions.

Why Did the IMF Caution the Fed?

The U.S. government is not alone. There are many other governments with government debt to GDP ratios over 100 percent. Each and every one of those governments is holding their central bank hostage. The lone exception is the ECB which does not technically have a single government to which it reports. Until recently, the ECB has shown little sympathy to the plights of Greece, Spain, Italy, and Portugal. But a negative interest rate policy is a subsidy to every government that is part of the eurozone. The IMF is simply trying to postpone the inevitable.


Decades ago I was privileged to learn monetary theory from Dr. Karen Johnson. She warned us of the dangers of running federal government budget deficits when the economy was reasonably healthy. Her main concern was what the government would do if the deficit was already large and the economy slipped into recession. Even with her intelligence, I doubt she forecasted how badly various governments have messed up their budgets.

[1] Economic Report of the President, 2015, Table B-22. Excel file can be downloaded from this link XLS. Accessed June 5, 2015.

[2] In practice, this will take some time due to the term structure of the U.S. government debt. T-bills will be affected almost immediately. But T-bonds will take quite a bit longer to be refinanced. As an economist, of course, I know this is irrelevant because the true cost of borrowing is the opportunity cost.

Watch for Interest Rates to Rise Soon

I missed this story on the Wall Street Journal website yesterday. Thanks to my lovely wife for pointing it out. “Overheard: Banks Shift From Treasurys to Loans” says that banks are chasing yields by starting to make loans again. Watch for interest rates to rise soon.

There’s one comment on this article by Frank Anderson: “This is scary.” I don’t know who Mr. Anderson is, but he’s absolutely correct. Banks have stashed about $2.5 trillion in excess reserves. When I last wrote about this, excess reserves were fairly stable at about 95% of total reserves.

Excess reserves as a percentage of total reserves

But over the last 15 months that percentage has begun to fall slightly.

Excess reserves as percentage of total reserves, last 15 months Watch for Interest Rates to Rise Soon

If we look at the year-over-year change in excess reserves, the pattern becomes clear.  (I used year-over-year changes because the data is not seasonally adjusted.)

Excess reserves, year-over-year change, last 15 months Watch for Interest Rates to Rise Soon

What’s It Mean?

What can cause excess reserves to decrease? The standard textbook answer is the Fed engaging in open market sales. But that would cause interest rates to rise (at least in principle — we’re in uncharted territory here). Although deciphering the Fed’s Table H.4.1[1] bears a close resemblance to reading tea leaves, it doesn’t look like the Fed has materially reduced its holdings of U.S. government securities.

That leaves us with the Wall Street Journal’s idea. Bank lending is picking up. There’s just a hint right now. But if this trend continues you can expect one (or possibly both) of these events:

  1. inflation will rise rapidly,
  2. interest rates will rise rapidly.

I’ve been writing about this for at least five years.  The Fed’s attempt to rescue the economy using monetary policy alone has been a fool’s errand.  Now they face a Sophie’s choice:

  1. The FOMC can do nothing, allowing those banks to continue to increase lending.  This will increase the growth rate of M1, M2, and (eventually) lead to inflation.  Right now M1 is about $3 trillion and M2 around $12 trillion. Even a relatively small value for the money supply multiplier (say 2.0), $2.5 trillion in excess reserves translates to a $5 trillion increase in M1.
  2. The FOMC can engage in open-market sales and take other actions to eliminate the excess reserves. The FOMC will have to act quickly. And this will cause interest rates to rise once the growth rate of M1 begins to slow.  Among other effects will be a sharp increase in the Federal government budget deficit as interest payments on the $16 trillion debt begin to rise. (A 10 basis point increase in the average interest rate on the government debt will increase interest payments on the debt by a cool $16 billion.  Even by government standards that’s not just spare change.

Note that either way interest rates rise.  If the Fed does nothing, inflation expectations will increase nominal interest rates.  If the Fed tightens, the reduced growth rate of the money supply will increase nominal (and perhaps real) interest rates.

Unsolicited Advice

My highly unprofessional advice: head for TIPS[2] funds. But remember: you get what you pay for.  How much did you pay for this advice?

(Disclaimer: my wife and I own shares in TIPS funds. However, this is irrelevant because (a) we are not buying or selling, therefore we don’t affect the market price; and (b) I’m pretty sure our holdings are a miniscule percentage of total TIPS securities held by the public.)

Transparency note: click here to download the usual Excel workbook.

[1] “Factors Affecting Reserve Balances of Depository Institutions and Condition Statement of Federal Reserve Banks” current release available at http://www.federalreserve.gov/releases/h41/Current/

[2] Treasury Inflation Protected Securities.

Monetary Policy is Like Pushing on a String

People seem to have forgotten this lesson. Central banks can only directly affect the quantity of bank reserves. That is the “push.” The money supply, however, only grows when banks lend those reserves. And that has been the source of the Fed’s problem since 2008.

The Fed has been buying securities at a furious rate. In 2013 our central bank bought around 70% of the net new issues of U.S. debt. And it has done almost no good. Banks are experiencing a quadruple whammy:

  1. The 2008 mortgage meltdown has made them more risk-averse,
  2. A hostile administration in Washington, D.C., seems ready to levy fines and file lawsuits whenever the U.S. Treasury needs funds,
  3. Huge regulatory uncertainty about how the Dodd-Frank Act will be implemented, and
  4. A fundamental lack of loan demand from their usual market: small businesses.

And they are not lending. They are sitting on huge piles of excess reserves.

Excess Reserves as a Percentage of Total Reserves

But what about the money supply? Here’s the unhappy picture:

Growth of M1, M2, and Reserves

Average annual growth rates of M1 and M2 are in the 6% – 8% range. Reserves have averaged 215.25% per year. Reserves are not being loaned. And until lending picks up the Fed might as well close up shop.

As always, my methods are transparent. Click here to download the usual Excel workbook.


While I don’t ordinarily use Wikipedia, the site can be helpful when trying to track down the origin of a phrase. (Footnotes are also copied from that source.) Forthwith,

According to Roger G. Sandilans[1] and John Harold Wood[2] the phrase was introduced by Congressman T. Alan Goldsborough in 1935, supporting Federal Reserve chairman Marriner Eccles in Congressional hearings on the Banking Act of 1935:

Governor Eccles: Under present circumstances, there is very little, if any, that can be done.

Congressman Goldsborough: You mean you cannot push on a string.

Governor Eccles: That is a very good way to put it, one cannot push on a string. We are in the depths of a depression and… beyond creating an easy money situation through reduction of discount rates, there is very little, if anything, that the reserve organization can do to bring about recovery.[3]

The phrase is, however, often attributed to John Maynard Keynes: “As Keynes pointed out, it’s like pushing on a string…”, “This is what Keynes meant by the phrase ‘Pushing on a string.'”[4]


Loan demand will not pick up until after the 2016 election at the earliest.  Until then, we’ll just have to try to hang on.

[1] Sandilans, Roger G. (2001), “The New Deal and ‘domesticated’ Keynesianism in America, in John Kenneth Galbraith and Michael Keaney (2001). Economist with a Public Purpose: Essays in Honour of John Kenneth Galbraith. Routledge. ISBN 978-0-415-21292-2., p. 231

[2] John Harold Wood (2006). A History of Central Banking in Great Britain and the United States. Cambridge University Press. ISBN 978-0-521-85013-1., p. 231; it cites U. S. Congress House Banking Currency Committee, Hearings, Hearings, Banking Act of 1935, March 18, 1935, p. 377.

[3] Ibid.,

[4] Joseph Stiglitz (April 8, 2008). “A deficit of leadership”. The Guardian (London). Archived from the original on May 13, 2008. Retrieved April 27, 2008.

Yellen Decries Wealth Inequality, Fails to Mention Fed’s Role

Dr. Janet Yellen

Dr. Janet Yellen

[Revised October 22 to correct the misimpression that the Fed is wholly responsible for the increase in inequality.  Thanks to Mark Dow @Mark_Dow for pointing out this issue.]

On October 17, Fed Chair Janet Yellen gave the keynote address at the Federal Reserve Bank of Boston’s 58th Conference on Inequality of Economic Opportunity.  The keynote was at 8:30 am, perhaps indicating that Dr. Yellen would rather not have had many attendees.  Indeed, given the content of her talk, such fears appear justified.  Dr. Yellen decries wealth inequality, fails to mention Fed’s role.  I hasten to add that the Fed’s policies over the past six years are just one factor causing inequality to increase.  Technological change, specifically the improvements in the speed of information transmission, are at least as important and probably a bigger factor.  That’s certainly the case in the long run.

A Maine farmer went to church one Sunday morning.  Upon departure he met a friend who asked him what the sermon had been about.  “Sin,” he replied.  “Well,” said the friend, “what did the preacher have to say about it?” The farmer replied, “He were agin’ it.”

Dr. Yellen’s idea is analogous to an old joke →

Exactly.  Dr. Yellen thinks there is too much income and wealth inequality in the U.S. today.  First, I have to note that this falls into “normative economics,” statements made by economists based at least partly on their opinions.  Now my opinions about, say, the minimum wage are likely to be more informed than years.  I get paid to keep up with the research.  But when it comes to opinion, yours is as good as mine — and both are as good as Dr. Yellen’s.

Second, what in the world is the Fed supposed to do about inequality?  At the moment, they can’t even perform one of their two main tasks: stimulating employment.  Oh, well, at least inflation is under control.

Until the Fed has solved the problem of the “zero lower bound” on interest rates, perhaps they should concentrate on their core mission and leave inequality debates to others.

Here are some excerpts from the Wall Street Journal coverage:

BOSTON—Federal Reserve Chairwoman Janet Yellen said rising inequality of wealth and income in the U.S. was impeding the economic mobility at the heart of American values.

“The extent and continuing increase in inequality in the United States greatly concern me,” Ms. Yellen said to a conference on economic opportunity and inequality sponsored by the Federal Reserve Bank of Boston. “I think it is appropriate to ask whether this trend is compatible with values rooted in our nation’s history, among them the high value Americans have traditionally placed on equality of opportunity.”

Ms. Yellen didn’t address Fed critics’ arguments that the central banks’ bond buys and zero-interest-rate policies have contributed to inequality by bolstering prices of assets such as stocks, which are primarily held by wealthier Americans.

The Fed counters its policies are aimed at boosting the overall economy, and thus helps lower-income Americans who are more likely to have high levels of debt.

It happens that the Fed critics are exactly right. While interest rates on debt held by those in the bottom 80% may be slightly cheaper, much of that debt is probably credit cards. Those interest rates are still way, way above 1%. Mind you, I have no problems with those rates. These are unsecured loans to borrowers, with no collateral at all. The high interest rates reflect the risk of those loans. Thus banks are able to borrow at low rates and lend to the poor and middle class at fairly high rates.  Again, I must add that these low interest rates are a contributing factor, not the sole reason for the growth of inequality.

Theory and a Hypothesis

Decades ago I studied monetary theory with Prof. Karen Johnson.[1] I learned this lesson over and over:

All assets are substitutes for each other. But some are better substitutes than others.

Central banks around the world have kept interest rates very low. The Fed, via their “quantitative easing” program has kept short-term U.S. rates near zero and longer-term rates in the 2% – 3% range. But portfolio managers need to turn a profit. They seek yield. If they can’t find it in U.S. government securities, they look elsewhere. Junk bonds, high-yield foreign bonds (and don’t forget Puerto Rico), and, yes, stocks. Probably real estate, too. Junk bond yields are in the 5% to 9% range. High-yield foreign bonds are around 4.5% – 6%. Where, oh where can they go?

Stocks, naturally. The stock market has boomed. There is widespread agreement among those with a clue that even a hint at higher interest rates would cause a selloff in the U.S. stock market and probably some other countries, too.

While U.S. stocks are more broadly owned than is generally believed (mutual funds, retirement accounts, etc.), it remains true that wealthier households own more shares of more stocks than less wealthy folks. And their wealth has risen accordingly.

Hence my hypothesis: the Fed’s policies have caused, at least in part, the increase in wealth inequality. I will not discuss the many, many other government programs that have the same effect. But I will note that the residents of the zip code 94027 are the largest purchasers of Tesla automobiles (price: $60,000 up). That zip code is for Atherton, CA, one of the wealthiest suburbs of San Francisco. I’m certain Atherton’s proud Tesla owners are also enjoying the tax benefits of their purchases.

Testing the Hypothesis

Using data from the Census I developed six measures of inequality.[2] They were:

  1. Percentage of U.S. households in the top 20 percent of income.
  2. Percentage of U.S. households in the top 5 percent of income.
  3. Median net worth (in dollars) of the wealthiest 20 percent of households.
  4. Percentage of households with a net worth of $500,000 or more.
  5. The ratio of mean to median net worth of the wealthiest 20 percent of households.
  6. The Gini coefficient for the U.S.

For the independent variable I used the yield on ten-year U.S. government notes. All data is annual. The independent variable and the Gini data are from the FRED database at the Federal Reserve Bank of St. Louis. All other data is from the Bureau of Census. For the ten-year note, I have data from 1980 through 2013. Other series vary both in length and continuity as noted in the following table.

Statistics Table

All coefficients of the interest rate are negative, indicating that lower interest rates increase inequality. Four of the five are statistically significant. (The lone exception is my constructed variable, the ratio of mean to median net worth.) Goodness-of-fit varies widely, but is generally better for the series with higher n’s.


Decades ago, Prof. Mike Hurd drummed another valuable lesson into my brain. Without some extensive and very difficult work, you cannot calculate the power of a statistical test. Unfortunately, that’s what you need to do to “confirm” a null hypothesis. As things stand, all I can say is that I failed to reject my null hypothesis.

For those interested, I have put my Excel workbook and the SPSS files into a zip file. Click here to download it.

[1] Dr. Johnson has now retired after a successful career at the Federal Reserve. Naturally she is not responsible for any of my errors — here or elsewhere!

[2] In some cases, my “development” consisted simply of copying the Census data into a format consistent with my original dataset.

Prof. Taylor Fails History


Paul Volcker

Paul Volcker

[Updated June 28, 2014 to add graph of M1 growth and link to Excel workbook.]

“Our credibility will ultimately be judged by how we do on both of these mandates, not just the price mandate,” Mr. (Charles) Evans said Tuesday night. “I think we will be judged very badly” if officials do not act forcefully to reduce unemployment and instead, he said, “worry obsessively”about inflation.

“There’s little more that we can do,” Mr. (Jeffrey) Lacker said of monetary policy. “There’s little more that we can contribute to growth.”[1]

– The New York Times, April 2, 2013


Congressman Goldsborough: You mean you cannot push a string.

Governor Eccles: That is a good way to put it, one cannot push on a string. We are in the depths of a depression and … beyond creating an easy money situation through reduction of discount rates and through the creation of excess reserves, there is very little if anything that the reserve organization [Federal Reserve Board] can do toward bringing about recovery. I believe that in a condition of great business activity that is developing to a point of credit inflation, monetary action can very effectively curb undue expansion.

– Testimony before the House Committee on Banking and Currency, March 18, 1935.

Monetary policy works better when you’re pulling the string. – Tony Lima

In today’s Wall Street Journal, Stanford Prof. John Taylor makes his case for a monetary rule, specifically one that targets interest rates. Those familiar with the “Taylor rule” will recognize this immediately as self-promotion. But we all do that. The larger question is whether an interest rate rule is the best policy in all circumstances.  In that regard, Prof. Taylor fails history.

Thankfully, a recent paper by Joshua D. Angrist, Òscar Jordà, and Guido Kuersteiner[2] has explored this issue. The question they examine is whether monetary policy has different impacts when it is contractionary versus expansionary. They conclude,

Application of this estimator to the effects of monetary restraint suggest contractionary policy slows real economic activity. By contrast, the Federal Reserve’s ability to stimulate real economic activity through monetary expansion appears to be much more limited. Estimates for recent financial crisis years are similar to those for the earlier, pre-crisis period.

In other words, monetary policy is more effective when an overheated economy needs cooling off. Expansionary policy, on the other hand, is not quite so effective.

History: 1975 – 1985

In 1978, former president Jimmy Carter appointed G. William Miller chairman of the Federal Reserve Board of Governors. The Federal Reserve’s official history pages describe Mr. Miller’s policies:

As chairman at the Board of Governors, Miller became known for his expansionary monetary policies. Unlike some of his predecessors, Miller was less focused on combating inflation, but rather was intent on promoting economic growth even if it resulted in inflation. Miller argued that the Federal Reserve should take measures to encourage investment instead of fight rising prices. He believed that inflation was caused by many factors beyond the Board’s control.[3]

The Fed’s historians are far too polite. Mr. Miller’s graduated from the “U.S. Coast Guard Academy with a bachelor’s degree in marine engineering. He later received a law degree from the University of California’s School of Law at Berkeley.”[4] He apparently had little understanding of economics. His policy was to target nominal interest rates. That caused a major problem that can only be understood in the context of the 1970’s.


G. William Miller Prof. Taylor Fails History

G. William Miller

This is the period described by economic historians as “The Great Inflation.” Inflation had been high and volatile for most of the decade. Macroeconomic models used then were woefully inadequate to handle the supply shocks of that time period. By 1978 financial markets had become sensitized to inflation.

A Digression on the Fisher Equation

Irving Fisher is usually credited with hypothesizing the relationship between the nominal interest rate (i), the real interest rate (r), and the expected future inflation rate (πe):[5]

Equation01 Prof. Taylor Fails History

Most of the time inflation expectations are backward-looking. That means markets expect future inflation will be about like the inflation of the recent past.

Equation02 Prof. Taylor Fails History

But, when markets are sensitized to inflation, expectations can become forward-looking. Instead of basing expected future inflation on past inflation, markets look at the underlying causes of inflation. And when inflation is high and volatile, markets will use the growth rate of the money supply to predict future inflation.

Equation03 Prof. Taylor Fails History

Note that expected future inflation now depends on the past growth rate of the money supply (m).

By 1978 markets were using forward-looking expectations. To make the model more realistic, I’ll add an external shock variable, s. During the 1970’s the main source of these shocks was oil price increases. I’ll also assume a three-period lag in expectations formation with α1 = 0.7, α2 = 0.2, and α3 = 0.1. Thus, our model looks like this:

Equation04 Prof. Taylor Fails History

Now assume a 6% shock in periods 1 and 2. Here’s the result:

Simple Model Prof. Taylor Fails History


Simple Model Table Prof. Taylor Fails History

What’s happening is simple. The shock increases the nominal interest rate. To reduce the nominal interest rate, the Fed increases the growth rate of the money supply. Markets see that increase (with a lag) and increase inflation expectations. That causes further increases in the nominal interest rate, leading to an explosive positive feedback loop. As always, click here to download the Excel workbook containing the above model and the macroeconomic data below.

A Personal Aside

Did this really happen in the late 1970’s? I have some inside information. I was working with Prof. George L. Bach at the time.

The Fed doesn’t think they can control interest rates.[6]

Dr. Bach was a member of the Fed’s Academic Advisory Committee. He came back from one meeting shaking his head. I remember his words clearly →

Our discussion expanded on that point as follows. If the Fed used expansionary policy, the markets would translate that into higher inflation expectations and interest rates would rise. But if the Fed used contractionary policy, the markets would notice the decreased liquidity — and both the real and nominal interest rates would rise.

Lee Bach was afraid. So was I.

The Cavalry Arrives

President Carter has a unique distinction among U.S. presidents. He made one of the worst appointments as Fed chair — and one of the best. Mr. Miller was appointed Secretary of the Treasury in 1979, serving in that post for two years. Mr. Carter then appointed Paul Volcker as Fed chairman.[7] Again, the Fed’s history website doesn’t do justice to Mr. Volcker’s actions. He quickly implemented a policy of targeting non-borrowed reserves. And he lowered the target aggressively. In language people can understand, that means Mr. Volcker shifted the policy instrument from nominal interest rates to the quantity of money in circulation.

M1 growth Prof. Taylor Fails History


Nominal Interest Rate Prof. Taylor Fails History

Interest rates spiked as liquidity vanished. The unemployment rate briefly exceeded ten percent.

Unemployment Rate Prof. Taylor Fails History


Real GDP Growth Prof. Taylor Fails History

The economy was put through a sharp, severe recession. But in four years the inflation rate was reduced to four percent. After that, Mr. Volcker began to expand the money supply, shortening the duration of the recession.

CPI Inflation Prof. Taylor Fails History


The point is straightforward. Those who advocate any kind of monetary policy rule must allow for exceptions. The Fed cannot be replaced with a computer. Arguing that the Fed should target interest rates when those rates are near zero is, frankly, silly.


[1] Appelbaum, Binyamin, “A Debate in the Open on the Fed.” New York Times, April 2, 2013. Available at http://www.nytimes.com/2013/04/03/business/a-debate-in-the-open-on-the-fed.html accessed June 27, 2014.

[2] Angrist, J. D., Jorda, O., & Kuersteiner, G. (2013). “Semiparametric Estimates of Monetary Policy Effects: String Theory Revisited.” NBER Working Paper 19355, September, 2013. © 2013 by Joshua D. Angrist, Òscar Jordà, and Guido Kuersteiner. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.

[3] From http://www.federalreservehistory.org/People/DetailView/42 accessed June 27, 2014.

[4] Ibid.

[5] This is an approximation. It’s good enough for what I’m doing here.

[6] Personal communication with the author, about 1979.

[7] http://www.federalreservehistory.org/People/DetailView/82 accessed June 27, 2014.