Monetary policy is one of the cornerstones of American economic
policy and the Federal Reserve is increasingly seen as one of America's
bedrock institutions while the Fed chairman is often viewed as Washington's
second-most powerful official. But, is this as it should be? Or
is the Fed chairman in fact nothing more than a real-world Wizard
of Oz? This article will first explain what present-day monetary
policy is and is not and then explain why money doesn't count, as
least as a major public policy concern. Interest rates, however,
do count enormously, because properly setting interest rates in
the commercial marketplace rather than in the political marketplace
in which the Fed operates, is central to ensuring price stability
and steady economic growth. The final portion of this article will
describe how a truly market-based, Fed-free monetary policy can
Contrary to most economic textbooks and popular mythology, monetary
policy does not consist of the Fed controlling the money supply.
The Fed readily admits as much. The Fed does not attempt such control
because it decided long ago to be an interest rate signaller. Like
all central planning agencies, the Fed understands that it can attempt
to control the price of credit (interest rates) or the quantity
of credit, but it cannot do both simultaneously. Because of the
near impossibility of directly controlling the credit supply (credit,
not money, is the real potential cause of inflation), the Fed, like
most central banks in the industrialized world, has elected the
far easier task of attempting to control, or at least influence,
interest rates. However, even in this arena, the Fed is rapidly
losing influence as the financial marketplace increasingly utilizes
electronic technology to create credit markets and global capital
flows over which central banker influence is rapidly diminishing.
The markets, playing the role of Toto, are steadily pulling back
the curtain to reveal what actually stands behind it.
Today, as a practical matter, monetary policy consists entirely
of just one short-term interest rate signal, the so-called Federal
Funds Rate Target (FFRT). The FFRT is the target interest rate that
the Fed sets for the rate at which banks lend to one another, usually
overnight, funds, or reserves, that they have on deposit at the
Fed. The Fed's open-market operations (buying and selling Treasury
securities) attempt, often not very successfully, to hold the actual
Federal Funds rate in the vicinity of the FFRT. Open market operations
also supply the banking system with reserves to meet its reserve
requirement, which is the amount of reserves that banks and other
depository institutions must hold in the form of currency or Fed
deposits as a percentage of reservable deposits. These are deposits
readily accessible by check or electronic funds transfer. Because
the Fed is a rate signaller and not a quantity controller, it supplies
banks with whatever reserves they need to meet their reserve requirement.
This means that the reserve requirement exerts absolutely no control
over the quantity of bank deposits, the other major component of
the money supply besides currency. Instead, reserves are merely
an expensive-to-administer tax on deposits.
Money (however defined) doesn't count for much in the U.S. economy
today because all forms of money are merely those portions of the
credit supply that also have the additional property of being convenient
media of exchange. Hence, a checkable bank deposit is a more convenient
medium of exchange than a mortgage although a mortgage serves as
a medium of exchange when it is assumed as part of a property purchase.
Credit plays the much more crucial economic role of financing the
ability to own assets in excess of one's own net worth or to mortgage
future income with unsecured debt such as credit card balances or
the federal government's debt. That is, while money may facilitate
a transaction, just as do charges against unused lines of credit,
credit permits the transaction to go forward in the first place
if the buyer lacks sufficient assets beforehand to execute the transaction.
Conceivably, a modern economy could operate without any money, with
all payments charged against unused lines of credit, but it cannot
operate without credit.
In a credit-based economy, which all but the most primitive are,
inflation occurs when credit expands so rapidly as to over-stimulate
demand for the then-existing supply of goods, assets, and services.
This excessive demand boosts prices at an inflationary rate. By
the same measure, if credit does not increase as fast as the supply
of what is offered for sale, or if the quantity of credit contracts,
then deflation can occur. Although rapid growth in the money supply
may accompany inflation, it is not the transacting property of that
money which is creating inflation, but rather the ability of the
issuer of that money to finance purchases with it. This is why the
government printing press is so often the cause of inflation. Fortunately,
the federal government no longer pays its bills in currency, instead
using checks or electronic funds transfers. Hence, the printing
press long ago ceased to be a cause of inflation in the United States;
that is, U.S. inflation is no longer a monetary quantity phenomenon.
In recent decades, U.S. inflation has been a monetary price phenomenon
because it has been caused by underpriced interest rates. As is
true with any good or other service, the demand for credit varies
inversely with interest rates. A nominal or stated interest rate
is underpriced, that is, too low, if it does not fully compensate
the lender for likely future inflation as well as providing her
with a sufficient real or inflation-adjusted return on the credit
she has provided after subtracting the other costs of supplying
credit, such as credit losses. On the other hand, a nominal interest
rate is too high if it overcompensates the lender for future inflation
after accounting for all other costs.
Left to themselves, financial markets will set nominal interest
rates which will produce non-inflationary credit growth: that is,
stable prices and the steady economic growth which stable prices
will stimulate. This is the case because in a large, competitive
financial market, such as the United States has, the bargaining
power of debtors and creditors is sufficiently balanced (the amount
borrowed always equals the amount lent) to properly set all interest
rates, from an overnight rate to 30-year mortgages. However, the
Fed, in its increasingly desperate search for a role in the modern
world, interferes in the interest pricing process by setting the
FFRT. Although it cannot in fact enforce the FFRT on other interest
rates through its open market operations, most participants in the
financial markets still believe, like the Munchkins' belief in the
power of the Wizard, that the Fed can enforce its will on at least
other short-term interest rates.
The virulent inflation of the 1970s and early 1980s was caused
by the Fed's then ability to signal all interest rates too low,
which in turn caused an inflationary demand for all forms of credit,
particularly long-term credit such as home mortgages. Over the last
decade, though, the financial markets have asserted complete control
over longer term interest rates. This control was especially evident
in 1992 and 1993 when long-term rates stayed high even as the Fed
snookered the financial markets into accepting excessively low and
potentially inflationary short-term rates. The Fed's continuing
success in pegging the short end of the interest rate yield curve
is harmful to the economy even as inflation continues its long,
market-driven decline. This is the case because today inflationary
and deflationary shocks (such as a jump in oil prices or a rise
in unemployment) are not fully reflected in short-term interest
rates, as they should be since most such shocks are relatively transitory
in nature. Instead, these shocks are reflected in an exaggerated
manner in longer term interest rates, which whipsaw those sectors
of the economy, such as housing and capital goods manufacturing,
that are most sensitive to interest rate fluctuations. In other
words, instead of experiencing sufficient volatility in short-term
rates, Fed monetary policy causes excessive volatility in longer
term rates, which harms the economy.
Fortunately, the American economy can easily be freed from Fed
monetary policy by simply abolishing the Fed's remaining monetary
influences. Key is barring the Fed's interest rate signaling; specifically,
the Fed's Federal Open Market Committee, which sets the FFRT, should
be abolished. Other needed changes include eliminating reserve requirements,
bricking up the discount window through which the Fed lends to the
banking system, shifting balances in the government's checking accounts
to private banks, repealing currency's "legal tender"
privilege (which increasingly is an anachronism), and shifting the
management of the nation's currency supply to the Treasury Department.
Stripping the Fed of its monetary functions will understandably
raise questions about its future, but those questions should not
stand in the way of freeing America from the last vestiges of the
Fed's counterproductive influence over the economy.
*Bert Ely, the principal at Ely & Company, Inc., Alexandria,
Virginia, is a banking and monetary policy consultant of long standing.
He can be emailed at email@example.com.
His website address is http://www.cais.com/ely.
Other articles and papers by Ely on monetary policy can be found