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Minyan Mailbag: The Fed Money Pump


The fed has set an artificially low interest rate. The market wants higher rates because it sees the problems these low rates are causing.


I would like to discuss some comments I've read about the "Fed pumping money." Jeff Saut said the same thing not too long ago. I am not trying to nitpick but isn't that an inaccurate representation of what is going on? It leads to all kinds of needless conspiracy theories about what the Fed is doing or why.

Now, correct me if I am wrong, but this Fed has chosen to defend an interest rate target. The Fed must supply all demand for credit at that target. If the Fed failed to do so, the interest rate target would not be hit and interest rates would either rise or drop accordingly.

I am a big fan of abolishing the Fed and letting the market set rates, but as long as the Fed has an interest rate target (as opposed to a money supply target) the Fed is not pumping money per se, the Fed is defending an arbitrary target that it has established, no more no less. Thus it is not the Fed initiating anything, the Fed is merely meeting demand for money at the arbitrary target they set.

Now, if the Fed instead set money supply targets instead of interest rate targets then interest rates would float day to day and money supply policy would be known. Yet every day I hear the same comments: "The Fed is pumping to save housing" or "The Fed is pumping to save the stock market" or "The Fed is pumping the PPT." All of this kind of talk is backwards. The Fed is meeting money supply demands at its target. Period. Typically the Fed has been meeting demand for money with repos. Repos are short term loans, not part of permanent money supply.

But people take these ideas about "pumping" as well as conspiracy theories about M3 and draw still more inaccurate conclusions as to what is going on. I can and will make a case that looking at M3 in isolation, it is missing the big picture (at least from an Austrian perspective) as to what is really going on with money supply. But that is another issue for Friday or early next week in my blog.

Right now, it's time to clear up this "pumping money" issue. Unless I am seriously mistaken, claims that the "Fed is pumping money" are putting the cart before the horse because by defending an interest rate target instead of a money supply target the Fed does NOT have a choice as to what the demand for money will be at its designated (and arbitrary) target currently set at 5.25%.

If I am mistaken and you all can clear up my misconceptions, I welcome the opportunity to learn. But otherwise we all need to be more careful when we use such phrases because it needlessly reinforces conspiracy theories that are running rampant.

Minyan Mish


Both are right…we are picking over semantics.

The fed has set an artificially low interest rate. The market wants higher rates because it sees the problems these low rates are causing: that money is getting into speculation and very low grade credit. The fed must supply enough new credit (repo) in order to keep rates from rising. The recent steepening of the yield curve is telling us that this is hard to do: they are doing too many repos trying to keep rates low.

If the Fed wants to stop pumping money they would admit that rates are too low and would raise them.

In fact, the recent steepening is very alarming. It is due to defaults/foreclosures/where lenders are saying they cannot continue to pass on to speculators/low quality borrowers of all that new credit the fed is trying to force into the market.

An inverted yield curve normally predicts a recession. That recession comes home to roost when the yield curve suddenly steepens out of that inversion: the market is tightening out of necessity just as the fed is trying to make it not to.

-Prof. Succo


There is another operational element here that very few folks appreciate and it is this: in setting the Fed funds target rate and defending it, the Fed's open market operations take the form of either pumping liquidity into or out of the banking system (via Fed Funds) in an effort to keep the target rate at (for now) 5.25%. Let's say that economic activity is heating up; there is more manufacturing activity, more employment, more lending by banks and as a result of all of those, more demand for short term monies by commercial banks. Bank lending activity goes up and their demand for short term money (the cost of which is set by the Fed) increases commensurately with their need to keep capital/coverage ratios at whatever bare minimum regulations demand they be. So, net/net greater economic activity implies more money demand by commercial banks. If money demand by commercial banks increased, in the absence of the Fed, we would see the 'cost' of the money (the interest rate) do what? Like all goods, when the demand for something goes up, the price increases in the short run.

So in the case of short term (Fed) funds, increased economic activity generates greater demand for short term funds by commercial banks and that increases the cost of those monies – increases the interest rate of these monies. But the rate – cost – of Fed Funds is 5.25% and the good boys at the NY Fed have pledged that it will defend the FOMC's Fed Funds target – neither letting it rise nor fall. But if increased economic activity is driving up the Fed Funds rate, then the Fed must increase the supply of credit in an attempt to keep the rate at 5.25%. This is of course a basic law of economics: in the face of increased demand, prices rise. The only thing that can keep prices the SAME would be an immediate increase in supply. And that is what the NY Fed does when economic activity increases – they increase the supply of monies in the system (via repos and other means) in order to defend that Fed Funds target.

More interesting than that is what happens when economic activity decreases. The opposite situation arrives: when economic activity decreases the demand from commercial banks for short term funds decreases and thus the price (rate) falls. In order to maintain and defend the fed funds target in a scenario where economic activity is decreasing and lending activity is slowing, the Fed has to decrease the supply of monies available to the system. Thus, the Fed will be taking money from the system once economic activity decreases unless and until they change the Fed Funds rate target. That period of time between a slowdown in economic activity and an eventual decrease in the Fed Funds rate can take months or quarters. If the size and severity of the misallocation of investments in the economy are significant, that period where the NY Fed open market desk is defending the FOMC's rate by decreasing monies in the system, need not be lengthy at all to create the kind of tightening of monies that is so anathema to a credit-driven, asset-based economy. A few months of taking money out of the system in order to defend a Fed funds target is all that is theoretically needed to create the type of tail event that I believe is highly probable in the credit and stock markets, not to mention the real economy.

The conditions of decreasing economic activity are present; the malinvestments are both huge and pervasive; the Fed could easily start to take money out of the system to keep the Fed Funds rate at 5.25%; and commercial bank lending declined last week more than it has at any time since February 1960. Those are the conditions – sufficient but perhaps necessary – for a credit-based contagion event. And few times in history have markets been implying the odds of this as so low.

-Prof. Reamer
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