--><div>
<font color="#002864" size="1" face="Verdana">http://www.mises.org/fullstory.asp?control=1540</font>
</div>
<div>
</div>
<div>
<font face="Verdana" size="2"><font color="#002864" size="5"><strong>The Fed Cannot Fix Itself</strong></font>
</div>
<font face="Verdana, Helvetica" size="4">By Frank Shostak</font>
<font face="Verdana, Helvetica" size="2">[Posted June 2, 2004]</font>
<font face="Verdana, Helvetica" size="2"><img alt src="http://www.mises.org/images3/fed.gif" align="right" border="0" width="183" height="230">In
his speech
on May 20, 2004, a Fed Governor, Ben Bernanke, argued in favor of a
gradual approach to interest rate policy settings. According to Bernanke,
because policy makers do not have precise knowledge of how the economy will
respond to a given change in interest rates it is logical that policy makers
should proceed cautiously.</font>
<font face="Verdana, Helvetica" size="2">In other words, inadequate
knowledge regarding how the economy works makes it appropriate for policy
makers to adjust policy more cautiously and in smaller steps than they would
if they had precise knowledge of the effects of their actions.</font>
<font face="Verdana, Helvetica" size="2">Furthermore, Bernanke holds that
the gradual approach allows central bank policy makers to have greater
influence over long-term interest rates. This in turn permits the Fed to have
more direct influence over the future course of the economy. In other words,
he holds that long-term interest rates are driven by the expectations of
financial markets participants about the likely future course of short-term
interest rates, which are in turn closely linked to expectations regarding the
federal funds rate.</font>
<font face="Verdana, Helvetica" size="2">Consequently, according to
Bernanke,</font>
<blockquote dir="ltr" style="MARGIN-RIGHT: 0px">
<font face="Verdana, Helvetica" size="2">In a gradualist regime, an
increase in the federal funds rate not only raises current short-term rates
but also signals to the market that rates are likely to continue to rise for
some time. Because they reflect the whole path of expected future short-term
rates, under a gradualist regime long-term rates such as mortgage rates tend
to be relatively sensitive to changes in the federal funds rate. Thus,
gradualism helps to ensure that the FOMC will have an effective lever over
economic activity and inflation.<a id="_ftnref1" title href="http://www.mises.org/fullstory.asp?control=1540#_ftn1" name="_ftnref1">[1]</a></font>
[/i]
<p dir="ltr"><font face="Verdana, Helvetica" size="2">It would seem, therefore,
that the formula for making the economy healthy is to make the central bank's
policies transparent and predictable. According to Governor Bernanke, it would
appear that transparent policies are good for the health of the economy
because this doesn't disrupt the fluctuations of relative prices of goods and
services. Consequently it is held that this allows the economy to move along
the path of stable economic growth.</font>
<font face="Verdana, Helvetica" size="2">Although Bernanke believes in a
market economy, he doesn't trust the notion that the economy can look after
itself. There are always various shocks that can throw it off the stable
growth path and pose a threat to the economy's well being. He believes that it
is the role of the central bank to put the economy back on the right path
because without the Fed's intervention the economy could even fall into a
black hole.</font>
<font face="Verdana, Helvetica" size="2">Thus if the economy falls below
the path of stable economic growth it is the role of the Fed to put it back on
this path by means of monetary pumping and the lowering of interest rates. If,
however, the economy exceeds the stable growth path the central bank must push
the economy back onto the path by slowing monetary pumping and lifting
interest rates.</font>
<font face="Verdana, Helvetica" size="2">In order to enable the Fed's
policy makers to guard the economy against various shocks, economists have
devised various formulas for the efficient conduct of monetary policy.</font>
<font face="Verdana, Helvetica" size="2">One of the most highly regarded
formulations as to how policy makers should conduct their policies was devised
by John Taylor <a id="_ftnref2" title href="http://www.mises.org/fullstory.asp?control=1540#_ftn2" name="_ftnref2">[2]</a>,</font>
<font face="Verdana, Helvetica" size="2">currently the under secretary of the
Treasury and a former Stanford professor of economics. According to Taylor’s
formulation, also known as the Taylor rule, the Federal Funds rate should be
increased or decreased in response to changes in real GDP and inflation. Thus
if real GDP rises above the potential GDP by one percent the Federal Funds
rate should be raised by 0.5 percent. If inflation rises by one percent above
its target of 2 percent, then the Federal Funds rate should be raised by 0.5
percent. Hence</font>
<blockquote dir="ltr" style="MARGIN-RIGHT: 0px">
<font face="Verdana, Helvetica" size="2">R=P+0.5*Y+0.5*(P-2)+2
Where
R is the federal funds rate
P is the yearly rate of growth in price inflation
Y is the percent deviation of real GDP from its potential</font>
[/i]
<font face="Verdana, Helvetica" size="2">This rule supposedly allows policy
makers to navigate the economy onto the stable growth path, which is reached
once real GDP is equal to potential GDP and inflation is equal to its target
of 2 percent. The Federal Funds rate, within these conditions, according to
Taylor should be at 4 percent. In short, the 4 percent Federal Funds rate
becomes neutral once the economy is on the growth path of stability since it
neither stimulates nor holds back economic growth.</font>
<font face="Verdana, Helvetica" size="2">Now, observe that this formula is
a framework for manipulating the entire economy, i.e., to target the pace of
economic growth and the pace of price inflation. Also, note that the target
for inflation is set at 2 percent. Why is that so? It is held that 2 percent
inflation is a good thing since it provides a buffer that prevents the economy
from falling into a deflationary black hole.</font>
<font face="Verdana, Helvetica" size="2">The fact that the Taylor rule
accurately depicts movements in the Federal Funds rate is the manifestation of
the interventionist mindset of the Fed.</font>
<p align="center"><img alt src="http://www.mises.org/images3/shostak/06-2004/1.gif" border="0" width="256" height="227">
<font face="Verdana, Helvetica" size="2">By influencing financial markets
players' expectations through transparent policies, the Fed presents itself as
a market servant. The Fed, it would appear, only validates what the market has
already decided. Thus the rise in long-term interest rates runs ahead of the
Federal Funds rate, i.e., the Fed is always seen as being behind the curve—it
does what the market has decided. Hence the Fed, i.e., Greenspan, is simply
exercising the market's wishes, or so it would appear to be the case.</font>
<font face="Verdana, Helvetica" size="2">Has transparency produced more
real economic growth?</font>
<font face="Verdana, Helvetica" size="2">In comparison to previous Federal
Reserve regimes it seems that Alan Greenspan's Fed is the most transparent.
Thus our examination of the data shows that it is only during the reign of
Alan Greenspan that market players were able to correctly anticipate the Fed's
monetary policies.</font>
<font face="Verdana, Helvetica" size="2">Our analysis shows that during the
period September 1987 to present on average the yield on the 10 year T-Note
has led the Federal Funds rate by 3 months (see chart). No lead, however, was
found during the reigns of previous Fed chairmen Arthur Burns and Paul Volcker.</font>
<p align="center"><img alt src="http://www.mises.org/images3/shostak/06-2004/2.gif" border="0" width="260" height="213">
<font face="Verdana, Helvetica" size="2">Has the greater transparency made
economic growth stronger? A conventional way of thinking would suggest that
all that is required in order to answer this question is to compare average
real economic growth in terms of real GDP during various Fed regimes.</font>
<p class="MsoNormal" align="center"><font face="Verdana, Helvetica" size="2">Average
real GDP rate of growth
</font>
<p class="MsoNormal" align="center">
<div align="center">
<table cellSpacing="0" cellPadding="0" align="center" border="1">
<tbody>
<tr>
<td vAlign="top" width="189">
<font face="Verdana, Helvetica" size="2">A.Burns 70.Q1-78.Q1</font>
</td>
<td vAlign="top" width="189">
<font face="Verdana, Helvetica" size="2">P.Volcker 79.Q3 - 87.Q2</font>
</td>
<td vAlign="top" width="189">
<font face="Verdana, Helvetica" size="2">A.Greenspan 87.Q3 -</font>
</td>
</tr>
<tr>
<td vAlign="top" width="189">
<font face="Verdana, Helvetica" size="2">
3%</font>
</td>
<td vAlign="top" width="189">
<font face="Verdana, Helvetica" size="2">
2.8%</font>
</td>
<td vAlign="top" width="189">
<font face="Verdana, Helvetica" size="2">
3.1%</font>
</td>
</tr>
</tbody>
</table>
</div>
<p class="MsoNormal" align="left"><font face="Verdana, Helvetica" size="2">According
to the table, Greenspan's transparent Fed policies did not create better
economic growth in terms of real GDP in comparison with the Burns and Volcker
regimes. In short, the fact that market players can anticipate the Fed's
actions doesn't mean that more economic growth will emerge as a result.</font>
<p align="left"><font face="Verdana, Helvetica" size="2">Furthermore, one
would expect that transparent policies would lead to more stable economic
growth and would not cause severe fluctuations, i.e., boom-bust cycles.
Examinations of trend-adjusted real GDP doesn't support this either. Sharp
fluctuations in economic activity also remained intact during Greenspan's
transparent regime (see chart).</font>
<p align="center"><img alt src="http://www.mises.org/images3/shostak/06-2004/3.gif" border="0" width="265" height="232">
<font face="Verdana, Helvetica" size="2">Why any policy of intervention
can only make things much worse</font>
<font face="Verdana, Helvetica" size="2">The entire idea that policies of
intervention can somehow bring the economy onto a path of stability is
untenable. A policy of intervention always benefits some individuals at the
expense of other individuals. It always leads to a redistribution of real
wealth and weakens the process of wealth formation. The fact that individuals
can correctly anticipate the future course of the monetary policy of the Fed
cannot undo the damage that such future policies will inflict on the economy.</font>
<font face="Verdana, Helvetica" size="2">When new money is injected there
are always first recipients of the newly injected money who benefit from this
injection. The first recipients, with more money at their disposal, can now
acquire a greater amount of goods while the prices of these goods are still
unchanged. As money starts to move around, the prices of goods begin to rise.
Consequently a late receiver benefits to a lesser extent from monetary
injections, or may even find that most prices have risen so much that they can
now afford less goods. In short, increases in money supply lead to a
redistribution of real wealth from later recipients, or nonrecipients of money
to the earlier recipients.</font>
<font face="Verdana, Helvetica" size="2">Likewise once new money is
injected, irrespective of whether it was expected or not, it will set in
motion the diversion of real resources from wealth generating activities to
activities that sprang up on the back of newly pumped money (the first
recipients of money). This monetary pumping, which is associated with the
lowering of interest rates, sets in motion the so-called economic boom.</font>
<font face="Verdana, Helvetica" size="2">Now, whenever the Fed reverses the
loose stance by slowing down monetary pumping and lifting interest rates it
arrests the diversion of real resources and weakens various activities that
emerged on account of the previous loose monetary policy, i.e., an economic
bust ensues.</font>
<font face="Verdana, Helvetica" size="2">Pursuing more transparent and
predictable monetary pumping cannot stop the damage that this pumping inflicts
on the last recipients of money and on the process of wealth generation. What
matters here is not expectations but rather real actions. Hence the only way
to avoid the damage is to stop monetary pumping altogether and the resulting
manipulation of interest rates.</font>
<font face="Verdana, Helvetica" size="2">Furthermore, to present the
economy as some kind of object that follows a growth path is an absurdity. The
so-called economy is just a metaphor—in reality there is no such thing as an
‘economy,’ there are only various individuals who are producing various
goods and services and exchanging with each other. There are no
means or ways available to measure and quantify the totality of these
activities since various heterogeneous goods cannot be added up into a
meaningful total. So if we cannot tell what the total product is obviously
there is no way or means to know what the so-called economy is doing.
Consequently, any policy which attempts to navigate the imaginary"economy"
only disrupts the process of wealth generation and undermines the well being
of individuals.</font>
<div>
<hr align="left" width="33%" SIZE="1">
</div>
<font face="Verdana, Helvetica"><font size="2">Frank Shostak is an adjunct
scholar of the Mises Institute and a frequent contributor to Mises.org. He
maintains weekly data on the AMS for subscribers through</font> <font face="Verdana, Helvetica" size="2">Man
Financial, Australia</font><font size="2">. Send him</font> <font face="Verdana, Helvetica" size="2">MAIL</font><font size="2"> and
see his outstanding Mises.org</font> <font face="Verdana, Helvetica" size="2">Daily
Articles Archive</font><font size="2">. Shostak wishes to express
thanks to Michael Ryan for his useful comments. Comment on this article on the </font>
<font face="Verdana, Helvetica" size="2">Mises
Economics Blog.</font></font>
<div>
<hr align="left" width="33%" SIZE="1">
</div>
<div>
<div id="ftn1">
<p class="MsoFootnoteText"><a id="_ftn1" title href="http://www.mises.org/fullstory.asp?control=1540#_ftnref1" name="_ftn1"><span class="MsoFootnoteReference"><font face="Verdana, Helvetica" size="2">[1]</font></span></a><font face="Verdana, Helvetica" size="2">Remarks
by Governor Ben S. Bernanke at an economics luncheon co-sponsored by the
Federal Reserve Bank of San Francisco and the University of Washington,
Seattle, Washington, May 20, 2004.</font>
</div>
<div id="ftn2">
<p class="MsoFootnoteText"><a id="_ftn2" title href="http://www.mises.org/fullstory.asp?control=1540#_ftnref2" name="_ftn2"><span class="MsoFootnoteReference"><font face="Verdana, Helvetica" size="2">[2]</font></span></a><font face="Verdana, Helvetica" size="2">John
B. Taylor Discretion versus Policy Rules in Practice. Carnegie-Rochester
Conference on Public Policy 39 (1993) pp. 195-214 North-Holland.
<div align="right">
<font face="Arial"><span class="567591613-06062002">
<div align="left">
<span style="FONT-SIZE: 12pt; COLOR: #333333; FONT-FAMILY: Verdana"><font size="1"><font color="#808080">In
response to many requests, it is now possible to set your credit-card
contribution to the Mises Institute to be recurring. You can easily
set this up on-line with a donation starting at $10 per month. See the</font>
</font><font size="1" color="#0000ff">Membership Page</font><font color="#808080" size="1">.
This is one way to ensure that your support for the Mises Institute is
ongoing</font></span>
</div>
</span></font>
</div>
</font>
</div>
</div>
</font>
|