Don't Fight the Fed, No Matter the Fundamentals
At the end of World War I, the United States faced an inflationary condition that threatened the stability of the economic system as it fought to move out from under the boot of wartime government measures. The inflation itself was a direct result of those means added to inflationary currency conditions, whose implementation could at least theoretically be excused by the exigencies of wartime necessities. The Federal Reserve System and Board were still relatively new at that time, and had little experience in a peacetime environment, let alone one in the grips of rapid consumer inflation.
To restrain the price increases rampant in the economy, the Federal Reserve began its first real experimentation with monetary "tightening." It explicitly and publicly announced increases in the discount rate, the rate charged to borrow "reserves" from its Discount Window liquidity facility. As rates rose to relatively high levels, the economy turned into the Depression of 1920-21. It was one of the worst downturns in history, and the worst to that point. In terms of wholesale prices, they had increased 150% between the adoption of the Federal System and its attempts at tight policy. Thereafter, from November 1919 to the cyclical trough in 1921, wholesale prices fell a massive and devastating 35%.
In no small part due to their experience with the discount rate and the Depression of 1920, the Federal Reserve would not appeal again to targeting an interest rate for another fifty years.
In the competing theories of central banking in the latter half of the nineteenth century, a central bank would have to target either the quantity of money or its cost. On the one hand, monetary theorists such as Henry Thornton (thought by many to be the father of modern central banking) and Knut Wicksell believed that money rates needed to follow or harmonize with the natural interest rate as determined in the real economy. The difference between the money rate and the natural rate was thought to be the genesis of inflation and deflation, and therefore price stability was attained through this matching process.
Additional factors were added through theorists such as Walter Bagehot who observed that money rates tended to be extremely unstable and unpredictable when left alone by the central bank.
"But though the value of money is not settled in an exceptional way, there is nevertheless a peculiarity about it, as there is about many articles. It is a commodity subject to great fluctuations of value and those fluctuations are easily produced by a slight excess or a slight deficiency of quantity. Up to a certain point money is a necessity. If a merchant has acceptances to meet tomorrow, money he must and will find today at some price or other. And it is this urgent need of the whole body of merchants which runs up the value of money so wildly and to such a height in a great panic. On the other hand, money easily becomes a ‘drug', as the phrase is, and there is soon too much of it."
In contemporary explanations for the economic course, the 1920's Fed began to shift blame for the inflation accompanying WWI, and thus the eventually cause of the depression that followed. It had not been the interest rate through the Discount Window that was to blame, but rather the quantity of borrowed reserves by banks. In this sense, Fed rationale was turning Bagehot's observation on its ear. The "money easily becomes a drug" is not due to cost, but unlimited quantity at any cost - such is the mania of price-driven "froth".
From that point forward, the operational constraint of the Federal Reserve's monetary policy would be a target of excess reserve balances at the banks. The Fed even detached from standard practice of holding the discount rate above market rates so as to discourage excess borrowing. Instead, the Fed's discount rate would be below market rates and would restrict excess usage f central bank facilities through moral suasion and "burdensome" administrative requirements.
Modern central bank and monetary theory holds these concepts to be wrong, and targeting of short-term interest rates to be "correct." But empirical history in the latter half of the twentieth century and into the twenty-first does not seem to conform to that interpretation. While the observations of Thornton, Wicksell and Bagehot should not be discounted lightly, perhaps there exists enough technological "innovation" post-World War II that renders their preferred central bank doctrine as less suitable for the modern system.
In the first sense, every instance that interest rate targeting has been used since reserve targeting fell out of favor has been associated with great inflation. Conventional economists will howl with outrage at such a statement, but there has to be some account for the asset bubbles that grew to absolutely immense proportions after 1995. These simply could not have been misallocations of "capital", and no sane observer can make the case given the immense growth of financialization not just in the US but globally. Global banks' collective stock of just foreign claims, for example, exploded from $10 trillion to $34 trillion in just the seven years between 2000 and 2007. Such balance sheet expansion, or currency inflation, is not accident.
In 1974, the Fed engineered its first interest rate targeting scheme since the 1920's. Toward the end of the 1960's, monetary policy had developed to incorporate the growing importance of the federal funds market and interbank wholesale money in general. The Fed set a two-month growth rate target of something called "private deposits" (a subset of required reserves) that was consistent with what it believed would be a desirable course for M1 growth.
But in targeting in this manner through the New York open market desk, the Fed feared too much volatility in the fed funds rate itself (pace Bagehot). To reduce this volatility, the Fed "installed" a rate corridor that actually came to dominate policy targeting. In applying that corridor the Fed's reserve targets were frequently missed and thus the federal funds rate became a de facto monetary target itself.
By late 1973, the Fed redefined private deposits as an intermediate target (which was dropped completely in 1976), evolving to a full-blown interest rate target by 1974. The targeting process would be fully explicit and public as it had been in the pre-1920 era, but it would not be immediate.
This mechanical change to policy construction corresponds with the highest and most sustained monetary-driven consumer inflation periods in economic history. Ironically, the Volcker Fed in 1979 would actually revert to reserve targeting through extremely complex methodology (that still carries some mystery to it). Apparently, the FOMC under Paul Volcker's direction used non-borrowed reserves as its target, derived from three-month growth rates of M1.
The system would still enforce a federal funds rate corridor, but it was widened relative to the narrow channel applied in the 1974-79 experience. The policy directive for January 1, 1980 was thus:
"...the FOMC seeks to foster monetary and financial conditions that will resist inflationary pressures while encouraging moderate economic expansion... The Committee agreed that these objectives would be furthered by growth of M-1, M-2, and M-3 within ranges of 1 ½ to 4 ½ %, 5-8%, and 6-9%, respectively...In the short run, the Committee seeks to restrain expansion of reserve aggregates to a pace consistent with decelerating in growth of M-1, M-2 and M-3 to rates that would hold growth of these monetary aggregates ... within the Committee's longer run ranges, provided that in the period before the next regular meeting the weekly average federal funds rate remains within a range of 11 ½ to 15 1/2 %."
Over the course of the 1980's, the Fed would adhere to some hybrid approach derived of reserve targeting mashed together with a federal funds corridor. At that time, the FOMC targets were neither open nor public, with the Fed only concerned about rational expectations and the anchoring of inflation expectations through its ability to conduct policy as it saw fit, free of publicly espoused targets. In this manner, secrecy and opacity were beneficial to what it saw as the new course in monetary construction.
We still do not know exactly when interest rate targeting was brought back as the prime variable for monetary targeting. Some place it around the change in leadership from Volcker to Alan Greenspan in 1987; while others think it may have been as soon as 1982. What we do know is that interest rate targets for the federal funds rate were announced in conjunction with FOMC policy meetings beginning in 1994.
Finally, it was not until 2003 that the Fed returned the discount rate to the traditional place above market rates, setting it 100 bp above the federal funds target.
Again, this time period of open interest rate targets corresponds with all manner of "irrational exuberance" that is traced directly to the explosion in debt and balance sheet inflation proffered by the banking system domestically and even globally (through the rising eurodollar/repo wholesale system that would contrive the shadow banking system).
In the reserve targeting era prior to 1974, the Fed was able to contrive policy that was largely hidden from view of the public and market agents. In some ways that created an illusion that money rates and interest rates in general were determined moreso by market forces than by policy. At that time, money rates floated with respect to the discount rate, creating the appearance that credit risk and expectations of inflation risk were the marginal forces involved.
But the Fed could have been and was in the background addressing whatever policy objectives it set without any public knowledge. For example, it could have used its open market operations to sell securities into the reserve markets, increasing the need for "borrowed reserves" and thus pushing the money rate upward in relation to the discount rate. In that way, the Fed could affect tighter money conditions without being public about it while still retaining the option of raising the discount rate to "push" markets if it wanted to by "surprise." From the perspective of the markets, there were little fingerprints of policy, and thus financial agents were actively seeking fundamental explanations for the movement in money rates.
It follows, then, that if markets were indeed "fooled" into the illusion that market forces were driving money rates that market participants might be primarily focused on their own perceptions of market forces. They would do so in disregard, at the margins, to central bank policy. In other words, banks would be far more likely to see and determine fundamental forces as being responsible for marginal movements in money and rates, and would therefore be much more attuned to fundamental forces.
Contrast such a possibility with the "markets" as they exist today. Market participants are certainly attuned to fundamental forces in some manners, but how much weight are they given particularly in comparison to estimations of current and future levels of QE? If marginal financial activity has shifted through interest rate targeting to give far more attention to policy than fundamentals, then might that have an impact on both the operations and psychology of markets themselves?
What I am implying here is that over time markets became far more focused on policy and the ability of central banking to "suspend" fundamentals in some Quixotic quest to manage economies and overcome natural economic progression. The reason we have seen so much more inflation (of all flavors) under the explicit interest rate targeting regimes is that market agents re-evaluate their own objectives inside a system that has changed marginal priorities and methods. Rather than place speculative bets on economic fundamentals as they are perceived at any moment, agents might rather change their bets and behavior toward policy objectives instead, regardless of whether market participants actually believe them credible. This is directly tied to perceptions of scarcity of money. In the "hidden" reserve targeting days where fundamental forces were believed primary, financial agents reacted to perceptions of scarcity; in explicit rate target regimes, scarcity is all but replaced as a concern.
In short, don't fight the Fed no matter how bad fundamentals get. In the 1990's, the "Greenspan put" was not just an inside joke for stock traders, it was widely believed credible and the explicit targeting of interest rates made it much more of a marginal factor in decisions. Lest anyone believe that this line of critique is far out of alignment with even conventional economic theory, I think that the wide acceptance of the rational expectations theory confirms and conforms here.
If rational expectations theory has any validity, and it does seem to in limited circumstances, it basically says exactly what I describe - that market and economic agents adhere to the future path of policy expectations in setting their own expectations. That would assume that unrelated fundamental perceptions have to be set aside, at least in some cases such as recoveries from recession, in order to do so. In terms of financial agents, such re-prioritizing of marginal factors appears much easier to do.
Perhaps that explains the problems with QE in the current context against the set of asset inflation. Economic actors themselves have far more constraints and priorities to set than do purely financial actors. Where rational expectations falls apart in the real economy setting, then, is in the complicated lives of individuals and businesses that cannot easily prioritize and internalize explicit central bank policy instead of our own perceptions. In other words, we don't easily become Fed-driven robots that spend on command when the FOMC is in "stimulus" mode.
Financial agents, on the other hand, are more easily managed by the allure of the "Greenspan put," or its Bernanke equivalent, and can digest priorities in the policy context much more closely.
I certainly do not believe that this tradeoff or difference between real economy actors and financial actors is the sole factor in the economy as it resists monetary management today. Nor do I think that rational expectations and explicit policy targeting is the sole factor in asset inflation and asset bubbles. But in my mind, at least, it makes a fair amount of sense to categorize how and why the economy and markets have taken the course in which they have.
It does not seem too far-fetched to believe that agents in either sphere would react to the explicit actions of central banks first, especially when considering that is exactly what central banks themselves expect. The application of rational expectations theory itself in the course of monetary management is nothing but an attempt to get actors and agents to engage in activity based primarily on central bank policy.
So what I may have proposed here is a weak form of rational expectations theory that has some critical limitations. There also seems, in this explanation, to be an undeveloped relationship in financial actors with the form of central bank policy. That is certainly far more complex in nature than is simply implied here, particularly in the short-term, but it does not prevent this dichotomy from occurring and growing. In attempting to get markets to see past current fundamentals and react more to the explicit course of monetary management, central banks may have actually and partially succeeded. The primary problem, as we can well see now, is that the susceptibility difference between the real economy and the financial economy appears to be a factor (maybe even a prime factor) in asset bubble formation without the more beneficial "stimulus" to the real economy.
