Friday, September 18, 2015

Is the Fed Pulling or Pushing?




I did a little interview with Mary Kissel of the Wall Street Journal, following up on thursday's oped. Mary is, as you can tell, a well-informed interviewer and asks some tough questions. She did a great job of pushing hard on the usual Wall Street wisdom about how the Fed, though it has not done anything but talk in years, is secretly behind every gyration of stock or housing prices.

The central point came to me hours later, as it usually does. Is the Fed in fact "holding down" interest rates? Is there some sort of natural market equilibrium that features higher rates now, but the Fed is pushing down rates? That's the conventional view, clearly expressed in Mary's questions.

Well, let's think about that. If a central bank were holding down rates, what would it do? Answer, it would lend a lot of money at low rates. Money would be flowing out the discount window (that's where the Fed lends to banks), to banks, and through banks to the rest of the economy, flooding the place with low-rate loans. The interest rate the Fed pays on reserves and banks pay to borrow from the Fed would be low compared to market rates; credit and term spreads would be large, as the Fed would be trying to drag down those market rates.

That is, of course, the exact opposite of what's happening now. Banks are lending the Fed about $3 trillion worth of reserves, reserves the banks could go out and lend elsewhere if the market were producing great opportunities. Spreads of other rates over the rates banks lend to or borrow from the Fed are very low, not very high. Deposits are flooding in to banks, not loans out of banks.

If you just look out the window, our economy looks a lot more like one in which the Fed is keeping rates high, by sucking deposits out of the economy and paying banks more than they can get elsewhere; not pushing rates down, by lending a lot to banks at rates lower than they can get elsewhere.

In reality of course, the Fed isn't doing that much of anything. Lots of deposits (saving) and a dearth of demand for investment (borrowing) drives (real) interest rates down, and there is not a whole lot the Fed can do about that.  Except to  see the parade going by, grab a flag, jump in front and pretend to be in charge.

49 comments:

  1. I vote for they haven't the vaguest idea of what they are doing or of what they should do.

    Neither does anybody else.

    "The owl of Minerva spreads its wings only with the falling of the dusk."
    Georg Wilhelm Friedrich Hegel (1770–1831)
    http://www.bartleby.com/66/78/27678.html

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  2. "reserves the banks could go out and lend elsewhere "

    Lending reserves?

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    1. "Repeat After Me: Banks Cannot And Do Not "Lend Out" Reserves

      https://www.kreditopferhilfe.net/docs/S_and_P__Repeat_After_Me_8_14_13.pdf

      It would be nice if people would clearly write, a model-and-clutter-free, and most of all, a well-defined, explanation of what they mean when they say "reserves the banks could go out and lend elsewhere."

      Isn't the problem now anyway banks have excess reserves - a problem not caused by large government bond purchases and other purchases by the Fed, but by an excess (net) deposit situation?

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    2. Yes, lending reserves. Over 70% of the reserves the banking system has parked at the Fed are "excess" reserves. They could be loaned out at any time by the individual banks; and, of course, if banks did more lending it would stimulate the real economy even more.

      This is actually a pretty good analytic post, especially considering our host's normal agendas.

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    3. Yeah, I am aware of how the banking system works. The first draft had a long explanation of banks "creating" money via loans, limits on that with reserve requirements (no longer binding) and capital limits, how discount lending raises reserves in the system, how individual banks can "loan out" their reserves though the system as a whole cannot, and so on and so on. It seemed to detract from the simple metaphor of the piece. But they are important clarifications, so thanks for commenters who want to expand on the point.

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    4. "Banks are lending the Fed about $3 trillion worth of reserves"

      'Reserves' are themselves loans to the Fed (they are Fed liabilities). As such it seems a bit odd to say that banks are 'lending the Fed about $3 trillion worth of loans to the Fed'.

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  3. By and large contractions in money are associated with increases in real interest rates.

    See http://www.philipji.com/item/2015-08-26/real-interest-rates-paint-a-gloomy-picture

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  4. Dr. Cochrane. Great point. Fed papers are obsessed with the "natural" rate of interest when they perhaps should be "looking out the window" to see what's actually going on.
    One quibble: As I have noted previously, banks don't "lend reserves" (or deposits). If you obtain a loan from the bank, you now have a bank deposit as an asset (the bank's liability) The loan is your liability and the bank's asset. Both you and the bank have expanded theirr balance sheets with the money supply increasing. This was all done with no reference to reserves - which are settled after the fact. That is, the money for the loan didn't "come from somewhere" - it was created out of thin air with accounting entries (debits and credits). Loans create deposits, not the other way around.
    Banks will make more loans when there are more customers meeting their standards showing up at the door. This activity has nothing to do with reserves. I hope that is helpful.

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    1. That's like saying that the food prices depend only on the demand. At the end of the day, the bank has to back his loans to a fixed regulated reserve (10% in my country). If it's getting to close, the bank will rase it's loaning standarts or rates, to minimize the risk of not complying to the regulator. This by itself is just like price-control on a very important component of the rates (if banks were to compete, the reserve rate vs. return rate on deposits will be an important factor that will reflect the risk-preferance of their cliants. If you combine fixed-partial-reserve with the exsistance of lander of last resort that is the money base of the central bank - yeah, it would definatly have an effect on real intrest rates.

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    2. Agreed. Factors beyond simply the demand for loans will impact loan volume. I was simplifying.

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  5. *Thank you* John, this is the best debunking that the Fed is keeping rates "artificially" low that I have ever read. It makes sense to a non-economist, i.e., someone who does not know what the Wicksellian natural rate is, and has the added benefit of being totally true.

    -Ken

    Kenneth Duda
    Menlo Park, CA

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  6. The deeper question is to what extent are (real) interest rates merely a social convention, not dictated by fundamentals.

    If you assume "not at all", then the Fed has no control over (real) interest rates. It must set them just so, or else it's guaranteed to fail, e.g. miss its inflation target.

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  7. That two trillion in "off shore" profits held by American corporations waiting for a tax holiday may have a bigger impact on short term rates than any thing the Fed is doing. In fact a substantial part of that $2T is probably included in the excess reserves at the Fed.

    Long term rates are a more interesting story. This article has a chart of long term rates going back hundreds of years: http://www.businessinsider.com/chart-5000-years-of-interest-rates-2015-9

    We should expect that long term rates will trend down over the long term as people live longer and capital markets become more efficient. When I look at the chart and consider the periods of peace and prosperity 1720 to 1750 and 1820 to 1900 (maybe include the 1950s) I see a trend line consistent with current long term rates around 3%. Long term risk free rates (over twenty years duration) in the 2.0% to 3% range may simply be the current market rate.

    I know that I am ignoring inflation. My attitude is that inflation is generally overstated as a result of problems with the definition and calculation and the real inflation rate (properly defined and measured) is currently effectively zero.

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  8. The Fed isn't doing anything? It's holding on to its balance sheet. What if it sold everything on its balance sheet.What, isn't like $4 trillion worth? Wouldn't that lower asset prices?

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    1. Ok, the Fed hasn't changed anything or taken any new action since the last QE3 bond was bought.

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    2. Professor Cochrane - I thought that the Fed was letting the bonds under QE mature so that QE was slowly unwinding. The most recent Fed statement says that they are rolling over principal repayments. The Fed could "tighten" by simply stopping the roll-over of long dated holdings.

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  9. Lately I've felt as though the financial world has turned into a giant #REF. The analyses circle back around on themselves. Some said QE was the solution because it would cause inflation. Others said it was dangerous because it would cause hyperinflation. Both turned out to be wrong. Despite trillions in QE we have had neither the targeted inflation nor hyperinflation. Unemployment is down, but not in a good way. The thinking about the effects of lowering interest rates, increasing money supply, etc is clearly dysfunctional with the possible exception of Mike "Mish" Sherlock, who predicted deflation and stagnation.

    I've read endless articles about whether banks don't want to lend or borrowers don't want to borrow or if banks can't find worthy borrowers. The latest iteration is that banks, whose stocks have managed to soar since 2009, are suffering from too low interest rates and just can't seem to scrape by because net interest rates are to low. Whereas they cheer layoffs in other sectors as making the companies leaner and more efficient, in their own back yard it's a tragedy whereby billionaire bank CEOs are "forced" to lay off thousands of employees because Ms Yellen didn't bump rates 0.25%. Actually they have been shedding jobs for years. My personal banking is done with an internet based bank. I haven't seen a teller in years. The last time I set foot in a bank was because I withdrew over $10,000 of my own property from my account and the government demanded to know what I used it for.

    I thought perhaps that at low net rates banks couldn't find a proper risk/reward level but someone, somewhere, is willing to buy junk bonds at traditionally AAA yields and there seems to be no trouble at all borrowing to finance stock buybacks.

    We received dire warnings from the IMF that a Fed rate hike would destroy the world but when no cut came there was no sigh of relief from markets. DAX down, Nikkei down, gold up. I can't keep track anymore of whether bad news is bad news or good news.

    IMHO this is all because Mises was correct about the inevitable consequences of a credit bubble and all these machinations have simply put off the day of reckoning and created massive illogical distortions along the way. We have truly gone through the looking glass.

    All I can say now is that when the possibility of a trivial hike in rates can cause panic around world we are in deep doodoo. It's a White Rabbit world.

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    1. I think we have some very large deflationary forces at work in the world including: Chinese savings rates; the Chinese workforce being integrated into the world economy; multinationals' profits from sales in America and Europe becoming stuck in tax havens (where they are invested in low yield US dollar instruments) rather than being recycled through the economy by way of dividends or excessive management bonuses.

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    2. Absalon, I think it's been hugely deflationary since 2008: a colossal unwind of loans to the non-creditworthy backed by overpriced collateral. All these machinations have been desperate attempts by rich and powerful people to maintain their status. For the past 7 years "cui bono"?

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    3. I think you guys are forgetting basics about nominal vs. real and where deflation comes from. Absalon has some interesting observations about real rates of interest, not the price level. And attempt to maintain status is a new theory of the price level to me. Let's first of all remember to distinguish real from nominal.

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    4. "Absalon has some interesting observations about real rates of interest, not the price level."

      What about the observation Absalon makes made about the integration of China. Surely the biggest economic shock to capitalism since the oil crisis? Very low labour costs and now a huge source of the world's production from virtually nowhere 30 years ago.

      Sure international interest rate effects from this probably also important - a huge balance of payments surplus that cannot be recycled domestically because of 'underdeveloped' financial markets and a highly regulated domestic market closed to outside capital.

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    5. Again, that's a real issue, not a nominal one. The question here is a "deflationary" pressure, not just a force for low real rates.

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    6. I think my problem in this discussion is that instead of addressing real vs nominal I'm hung up on real vs theoretical. The fact that the current chicken or egg discussion even occurs signifies to me that any current theoretical framework is insufficient to explain this incredible mess whereas "greed and malice" explains a lot.

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    7. Professor Cochrane: I am agreeing with you that the interest rates may be market driven more than they are set by the Fed.

      I meant all references to interest rates in my reply to JB McMunn to be references to real rates. As I said in a comment up the page I suspect that the "real inflation rate (properly defined and measured) is currently effectively zero."

      I believe that we have deflationary pressures. The integration of the Chinese labor force puts downward pressure on wages in the whole developed world. There has been a surge in global savings and interest rates have fallen. The rise in new investment has not been sufficient to offset the drop in consumption. That surge in savings is partly artificial: the official Chinese accumulation of reserves as a merchantilist and strategic policy; the accumulation of cash in tax havens by companies like Apple and Google, and probably other American and European businesses who do not report publicly, waiting for a tax holiday. The Fed has intervened with some effect to offset the deflationary pressures (particularly their purchases of MBS) but they seem to have just brought us back to something like zero inflation.

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    8. " "greed and malice" explains a lot."

      We have always had greed and malice. That is not new. Part of the problem we are having is that the system has so many moving parts and the linkages are not clear and are not agreed on. I think we agree that markets clear but we don't always seem to agree on the practical consequences.

      To me it seems clear that the accumulation of untaxed profits by Google and Apple and others in tax havens is deflationary and that some of that money is the money that is showing up as excess reserves at the Fed.

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    9. @JB McMunn, what evidence would convince you that Mises is wrong? Can you tell us ahead of time what that might be? Or is Mises unfalsifiable?

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  10. http://moslereconomics.com/wp-content/graphs/2009/07/natural-rate-is-zero.PDF

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  11. Interesting post. One could add that the federal government borrows large sums up money thereby possibly artificially boosting interest rates. Additionally the federal government provides FDIC insurance, thus also providing a safe haven for deposits.
    On net, I would guess the federal government, including the Federal Reserve artificially boost interest rates, and yes interest on excess reserves is another factor.

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  12. "Raising Rates could actually Stimulate the US Economy"

    In case anyone missed my previous comment on The Grumpy Economist:
    http://johnhcochrane.blogspot.co.uk/2015/08/whither-inflation.html?showComment=1441314105597#c7344464031910490481

    Although the Fed surely don't expect raising rates to stimulate the economy, it is plausible that by putting more money into the economy by paying interest on excess reserves to the banking system, raising rates could actually stimulate additional aggregate private sector borrowing. Bottom line of course, no one knows for sure. All the Fed can do is to experiment. But if raising rates does actually stimulate the economy, it’s possible that the terminal dot-plot level could also be reached much sooner than anyone currently expects.

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    1. Raising the rate the Fed pays on reserves does not put more money into the economy. It simply means that the spread that the Fed earns (the difference between what it pays on reserves and what it earns on notes and bonds it holds) will go down and the Fed will end up giving less money to Treasury at the end of the year.

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  13. As some other commenters also allude to, the notion of "lending out reserves" simply does not make sense. If a bank makes a loan to a business or a household, it increases loans on the asset side of the balance sheet and deposits on the liabilities side. There is no change in reserves.

    Of course, the business or household will presumably want to spend that money. Maybe they are buying stuff from businesses which use other banks, and doing so requires an interbank transfer. That transfer, however, also does not change reserves: It simply redistributes reserves between banks.

    How exactly is it that lending changes reserves? I've often heard this claim, and I just don't get it. Could someone (who believes this to be the case) please explain it, preferably using concrete examples involving bank balance sheets (so it'd be transparent if there are flaws in these examples).

    I am more familiar with the operational setup in European Central Banks so possible it is different at the FED. In general, though, it would seem that reserves can be altered by: 1) central banks printing money (e.g. to finance LSAPs, maintaining a fixed x-rate or for some other purpose), 2) banks using central banks' facilities, e.g. by borrowing from the CB (which increases reserves), or 3) by banks withdrawing or depositing cash from or with the central bank (the former reducing reserves, the latter increasing it). 4) In some countries, the govt also has its account with the CB, so transfers to and from the government also change total bank reserves.

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    1. Banks are required to hold a level of reserves. Banks are holding $2.5 Trillion dollars in their reserve accounts OVER AND ABOVE the amounts they are required to have on deposit with the Fed. https://research.stlouisfed.org/fred2/series/EXCSRESNS.

      When Professor Cochrane referred to lending from reserves, I understood him to mean lending from the excess reserves not from all of the reserves. The banks in effect are choosing to lend that $2.5 Trillion excess to the Fed rather than to customers. I suspect that this has interesting monetary and macro economic consequences.

      I have read that most of the excess has been deposited with the Fed by foreign banks. People (perhaps drug dealers, Russian oligarches, tax evaders and avoiders, multinationals) seem to be depositing US dollar assets with banks that have no sufficiently effective way to make US dollar loans.

      Anyway that is my take on the issue which seems to have bedeviled some of the commentators on here.

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  14. Bank lending does not impact total reserves. However, it can often impact reserves for an individual bank. If you take out a loan from Bank A and end up depositing the proceeds in Bank B - reserves for bank A will decline - offset by the increase in reserves for Bank B.
    Perhaps that is source of some confusion on the subject.

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  15. Actually it sounds a bit strange to me. What I think traditionally happens during a business cycle pick up is that investable opportunities keep coming up, and monetary conditions are tightened to moderate the heating up. What I understand from the article is that market is doing the job of tightening the rates, yet accompanied by dearth of new investable opportunities -- doesn't that sound like a peak of business cycle? Please correct me if I am missing something.

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  16. John,

    "That is, of course, the exact opposite of what's happening now. Banks are lending the Fed about $3 trillion worth of reserves, reserves the banks could go out and lend elsewhere if the market were producing great opportunities."

    That is a misrepresentation of what is going on. The central bank is never a borrower. Instead the central bank is holding about $3 trillion of federal government debt and it is requiring the private banking system to hold that federal government debt through reserve requirements.

    If the federal government were interested in having the private banking system seek lending opportunities elsewhere, it would cease borrowing.

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    1. The Fed is not requiring the banks to deposit those excess reserves. The Fed is using those excess reserves to buy Treasuries. In one sense, to the extent of the excess reserves, the Fed is acting as a giant money market mutual fund which: (1) has zero management expense costs for investors; (2) is instantly redeemable at par; and (3) can never break the buck. Depositors and banks may prefer to invest in Treasuries indirectly through the Fed over investing directly in Treasuries.

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    2. Absalon,

      "The Fed is not requiring the banks to deposit those excess reserves."

      I think they are in fact requiring backs to deposit those excess reserves.

      If the Fed calls up a private bank and says "Give us all your treasury bonds for dollars", can that bank refuse? How do open market operations work if the market refuses to sell at any price?

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    3. "How do open market operations work if the market refuses to sell at any price?"

      At some sufficiently extreme price people will go short and sell the Fed Treasuries they have borrowed.

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    4. Why would the Fed engage in open market operations to buy Treasuries only to lend them back out?

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    5. I did not say that the short sellers would borrow Treasuries from the Fed.

      They could borrow Treasuries from anyone holding Treasuries who was willing to accept the security and payment being offered.

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    6. Absalon,

      You said: "At some sufficiently extreme price people will go short and sell the Fed Treasuries they have borrowed...They could borrow Treasuries from anyone holding Treasuries who was willing to accept the security and payment being offered."

      Okay, person borrows Treasuries from the market and sells them to Fed. Presumably that person hopes to buy back those Treasuries (from the Fed?) at a lower price and return them to the lender.

      Question: Why would the Fed accept a lower price for the Treasuries than what the Fed paid for the Treasuries? Under the Federal Reserve Act, the central bank is not permitted to buy securities and sell them at a loss.

      So my question still remains - "How do open market operations work if the market refuses to sell at any price?"

      Selling Treasuries short is not profitable when dealing with the central bank because the central bank is not permitted to take a loss.

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  17. Dr. Cochrane,


    The current interest rates are well nigh "normal", which is to say that even without the Large Scale Asset Purchases (LSAP), which were part of the Quantitative Easing Policy (QEP), interest rates were already low. QEP began in December of 2008. The Effective Federal Funds Rate was 0.38% in November 2008, before any LSAP. Today the EFFR is 0.13%. QEP, after trillions of dollars of Open Market Operations (OMO) and seven years, lowered the EFFR all of 25 basis points. Current Federal Reserve Bank monetary policy is not really all that far from "normal", at least in terms of interest rates.

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  18. John, instead of rates, could it be that the Fed has suppressed NGDP, and therefore kept rates low? In other words, perhaps money is tight and therefore nominal growth is slow?

    "Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

    After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die."

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  19. John, you write:

    "Banks are lending the Fed about $3 trillion worth of reserves, reserves the banks could go out and lend elsewhere if the market were producing great opportunities."

    So, I see you and Paul Krugman agree about that (from his series on permahawkery and what he thinks motivates it):

    "Incidentally, this also means that the common claim that QE is a giveaway to bankers is the opposite of the truth; to the extent that journalists with close ties to bankers spread this story, it’s Orwellian. Remember, the Fed isn’t lending money at low interest to banks — banks, with their $2.5 trillion (!) of excess reserves, are lending vast sums at low interest to the Fed."

    Link here.

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  20. Krugman, as usual, turns reality on its head. Getting a capital infusion from the Fed is not an act of charity on the part of the banks (low interest? boo-hoo). Fed-created liabilities to the banks is the Fed rescuing an overleveraged banking sector. The Fed absorbs senior Treasury bond assets from the public, and emits bank reserves liabilities for the exclusive use of the banks.

    Without reserves, banks don't clear... anything. Instead, reserve-based QE is a giveaway of senior capital to the banking sector. The banking sector got too far over its skis with leverage, and the Fed handed them asset capital in response to a asset-liability mismatch. Bottom line, bank reserves only support the debt markets, and have no direct nexus with NGDP at all.

    At a "money price" of zero rates, the demand of short-term income is high and the supply of income is low: this produces low debt yields/high debt prices. Per Friedman, when yields are low, money is tight, NGDP is scarce, and income only comes at a high price.

    It's tight money, all the way down. The business of banks is debt. Tight money raises the price of debt, lowers NGDP, and lowers yields. For bankers, tight money is great -- it makes a bull market in yield-seeking (and all the speculation and financial engineering that goes along).

    So, QE reserves have nothing to do whatsoever with the public: it's all about debt, and therefore all about banks. The public could -- possibly, it has yet to be seen -- withdraw its senior capital from the banking system in the form of banknotes. Take out currency, and banks lose their IOR-paying assets.

    Senior base money circulating outside the banks might just loosen monetary policy for the nominal economy: pay in cash. But, the Fed & Treasury say you cannot have your cash, or else you are a criminal suspect: i.e. tight money by statute.

    The Fed is the permahawk. It's tight money all the way down.

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  21. Yes the Fed is holding down interest rates but by doing so it is also holding down the velocity of money. As long as it keeps both down inflation seems under control. However, the velocity of money also depends on inflation so it can develop a feedback loop as that goes up if it keeps rates down for too long. My guess is that we have passed the "too long" time period already and they will be losing control in the next year or two.
    http://www.howfiatdies.blogspot.com/2015/09/punchbowl-removal-difficulties.html

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    1. How will you know if you're wrong? I assume part of your answer would be that "they" (the Fed?) won't loose control in the next year or two, correct? But what else needs to be true for you to be satisfied that you're wrong? I'm not saying you ARE wrong, I just want to know specifically how you'll be able to tell.

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    2. I expect the Fed to lose control of inflation over the next year or two. If we keep having low inflation then I am wrong. When they were lowering interest rates they were also lowering the velocity of money, so they did not cause inflation. But when the velocity of money starts going up raising interest rates causes it to go up more. So it is much easier to move to easy money than it is to stop. If the coming decade reminds people of the 1970s or worse then it is what I am thinking of, if we keep getting low inflation and low interest rates then I am wrong.

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    3. Thanks for your answer Vincent. That's pretty good. I'm forever asking economists a variation on that question (i.e. "How will you know if you're wrong?") and very few of them can come up with anything approaching a concrete answer for me. It's almost like they've never even seriously contemplated the question before. It's funny, both you and Jason Smith are really the only ones who've provided me anything like a concrete answer, and you're both amateurs! Not that amateurs normally provide me an answer either, BTW. For example, I asked Major Freedom once and got a lecture about how economics isn't empirical and can't be falsified (if done "correctly")). At least I think it was MF... I hope I'm not slandering him. It was someone with a similar view if not him.

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