The Reykjavik Scenario (or How Interest Rates Can't Control Monetary Inflation) 31 comments
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Iceland is a live example that it is not possible to control monetary inflation and the resulting price inflation by adjusting the general level of interest rates.
Iceland is known for its (free) geothermal energy. Even this gift of nature was unable to save the country from the decennial of mismanagement by the authorities and banks.
For the USA and the EU, this small island has become an example which is a lot closer than Zimbabwe.
The key factor in Iceland's failure has been the monetary policy pursued by its Central Bank, in particular inflation targeting, similar to the UK, Hungary, the EU and the USA.
Iceland is the live proof that it is impossible to control Inflation by raising and lowering interest rates. This method simply doesn't work. Monetary inflation and the resulting price inflation are the direct result of the money supply. Interest rates have absolutely no impact on the resulting price inflation. They rather are a consequence of the level of monetary inflation.
Central Banks targeting inflation by raising interest rates if inflation is above the target and lowering them if inflation is below target, are run by illiterates.
Interest rates are a consequence of and not the origin of a monetary policy. Interaction by the authorities will sooner or later always lead to accidents.
In Iceland, interest rates exceeded 15% at times. In a small economy like Iceland, high interest rates both encourage domestic firms and households to borrow in foreign currency, and also attracted currency speculators. However, other factors, such as deleveraging and repatriation of funds, like we have in the USA, can result in exactly the same situation.
This leads to large inflows of foreign currency, leading to sharp exchange rate increases, giving the Icelanders an illusion of wealth.
The end result was an exchange rate which was increasingly out of touch with economic fundamentals. As a result, in the end a rapid depreciation of the currency became inevitable.
The Icelandic banks had foreign assets worth around 10 times the Icelandic GDP, with debts to match. Similar and worse conditions exist(ed) in the EU and the USA. (CDO Subprime). As long as the economy was expanding, there was no problem as the leverage worked in favor of the banks. However, because of fractional reserve banking, fiat money, the credit crunch and the resulting deleveraging of the balance sheets of the banks, the mechanism started to work in a negative way; as a result, the Icelandic banks became insolvent!
The relative size of the Icelandic banking system and the monstrous leverage made it impossible for the government to guarantee the banks.
This effect was further escalated and the collapse brought forward by the failure of the central bank to extend its foreign currency reserves. (The day will come that the Federal Reserve will be confronted by a similar situation)
The final collapse was brought on by the bankruptcy of the entire Icelandic banking system.
As a result, we see the same symptoms as Zimbabwe:
- At the moment, the Icelandic economy has come to a standstill.
- Imports of goods have become impossible: shelves are empty, car sales have halted.
- The Icelandic currency keeps on falling due to the currency speculators running for shelter.
- Icelandic households see their payments on loans increased by up to 50%.
- Inflation may reach 30% or more this year (hyperinflation).
- Wages are frozen.
- We have mass layoffs.
In the USA, we have a similar situation as Iceland had before the crisis started. The dollar, which has been rising because of the credit crunch and deleveraging, is in exactly the same situation as Iceland was before it all started to happen. The total size of the derivatives (800% of World GNP) and the trillions of freshly created money will result in a similar situation. Ironically, interest rates in the USA are historically LOW and this will over time prove it is impossible to control monetary inflation and the resulting price inflation with adjusting the interest rates. This theory is a fallacy.
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This article has 31 comments:
That might be the funniest thing I've ever seen written on seekingalpha.
By the way, there is no compelling argument made here.
But, several corrections:
1. Hyperinflation is 50% or more in a month. 30% a year is high inflation, but not a total disaster. Zimbabwe has hyperinflation. Iceland is far from it, AFAIK.
2. In normal times, interest rates do control money supply. You are right, these are not normal times.
3. Inflation is a function of money supply and money velocity. What I see in Iceland is higher money velocity (nobody wants to hold local currency, people are trying to get rid of it as soon as possible). We have quite opposite situation in US right now: Everybody is hoarding dollars and doesn't want to spend them.
And, of course, huge lesson to everybody: currency carry trade is not easy money. It's a complicated risky business.
But wouldn't you agree that more money is loaned (or supplied) at low interest rates than at high interest rates in line with the law of supply and demand?
If I offered you the chance to borrow $1 million at 2% interest, would you take it? Um... yes! You'd take the cash and find a way to earn 3% on it, generating $100k profit per year. How about at 10%? Maybe not. There are far fewer opportunities to safely profit on such a deal, so fewer such loans are made (the GE / Buffet deal being a notable exception this year! Isn't GE ambitious!).
That said, the majority of surveyed economists agree that when the government creates too much money, inflation can occur. That's what happened in Zimbabwe. In Iceland, however, they weren't printing billion-dollar bills to keep the army & police loyal, they set themselves up to be the victims of the inevitable deleveraging and repatriation of dollars and euros that had previously flooded the economy...yes... seeking yield on high interest rates. Zimbabwe's and Iceland's currencies devalued for different reasons: one due to internal money printing, and the other due to external investors having to flee the currency.
In the US, risk aversion and big losses among banks have curtailed lending more than 10% interest rates ever could. This is deflationary. Yet, the govt. is creating money like crazy (bailouts, "stimulus" checks) and dropping overnight lending rates to 1%, which is inflationary.
The sum of these competing pressures is anyone's guess. Commentators cannot decide if we will be Japan 1990 or Germany 1930. Probably we will be neither. Whether or not foreign investors flee the dollar will in part be determined by whether they have less risky alternatives. That's why the yen has been rising lately.
Finally, gold is not money, much less the base of the world economy. It is a commodity mineral useful in electronics and jewelry manufacturing. You might as well substitute nickel, copper, silver, platinum, iron, oil, or lumber.
Did anyone hold a gun to currency speculator's heads and force them to buy Krona, even as the money supply expanded?
Nope, just a bubble like any other, caused by trend followers all making the same bet and thinking they can all be right, as long as it keeps going.
No government policy can outlaw the stupidity of free men. If enough people act stupidly enough on a big enough scale, they can wreck things. Duh.
The assets that secure the debts issued by Iceland banks are the assets they purchased abroad with the funds lent to them. If those assets are worth less than the nominal value of the debts, whoppie doo, they are all the creditors own because they are all the creditors can own. If that makes Krona worth a bit less, tough toenails.
But if the Iceland authorities now put rates high enough, they will kill the inflation stone cold dead, just as happened in the US in 1982. All it requires is the political will to be fair to capital, foreign or domestic.
To avoid distressed sales of the foreign assets owned by the banks at the worst time for it, the IMF can loan to the government, which can use the proceeds to pay off foreign creditors. As markets recover and foreign assets continue to earn out, they are realized and used to retire the debt to the IMF.
None of the past actions or losses are going to matter much at all, in any of it. Only their forward policies will.
Money isn't magical or exotic or dangerous, and it isn't the only real asset with others being fake. It is merely one narrow asset among many others. And right now there is a manic demand for it. Selling long dates claims at fire sale prices to get money when the money is yielding nothing and useless, is insane. But leveraged debtors have been forced to it, and others are mimicking them in monkey-see, monkey-do trend following fashion, instead of sensibly taking the other side and collecting all the long dated claims.
The fever will break, and everyone who used the occasion to sell everything to get into money, will have given away their future wealth to those who made the opposite call.
"Iceland is a live example that it is not possible to control monetary inflation and the resulting price inflation by adjusting the general level of interest rates."
Um, how exactly do you think the central bank goes about adjusting interest rates? Do you think they just walk outside and put a new number up on a chalkboard, and poof, there's the new interest rate?
No - the bank adjusts the money supply to cause an equilibrium change. So while you're right - the money supply is not affected by changing interest rates - this article is completely off-base because the underlying premises are simply untrue.
"The dollar, which has been rising because of the credit crunch and deleveraging, is in exactly the same situation as Iceland was before it all started to happen."
Incredibly, enormous, observably false. The dollar (and yen) have both been rising in part because they are seen as the safest currencies in the world, and there has been a perhaps unprecedented flight to quality. Did anybody anywhere in the world ever think of the Icelandic currency as safer than the dollar, or the yen, or the euro, or the pound?
"The total size of the derivatives (800% of World GNP) and the trillions of freshly created money will result in a similar situation."
Except that the massive reduction in M3 is enormously DEflationary. The reduction in leverage IS a reduction in the money supply, and so the increase in the money supply by the Fed is counteracted. The trick comes down the line, when the Fed will need to reduce the money supply as leverage recovers to avoid inflation.
What the Europeans are missing is that their higher interest rates are not having the expected effect of drawing more deposits, as fear has heightened risk aversion. Europe is also experiencing a similar deleveraging-induced contraction in the money supply and needs to move to lower rates as the Fed continues to do. Look at 3-month LIBOR, which remains seriously elevated.
Monetary inflation is the result of the creation of Fiat Money out of thin air. Monetary inflation ALWAYS results into a price inflation whatever the level of interest rates is...
History shows this over and over again: Weimar, Zimbabwe, the Civil war in the USA, the american independence,...Please make your home work and get a good history book.
Greenspan stated before Congress that "His concept of Financial Economics was flawed and had been flawed for the Past 40 years, to his "surprise". This time frame includes Mr. Volcker's Deep Recession outcome.
Will this time be different if Economics 101 is flawed?
Really? Look at the data (www.federalreserve.gov.../). Between 10/06 and 10/07, In the last year, the non-M1 components of M2 increased by 7.11%. Between 10/07 and 10/08, the same measure increased by 8.19% (estimate based on three weeks' data). When you consider the actions of the Fed during these two periods, the small difference in growth in M2 is jarring.
Between 10/06/31 and 10/07/31, the federal funds target rate was changed twice, from 5.25% to 4.75% on 9/18/07, and to 4.5% on 10/31/07. Between 10/31/07 and 10/31/08, the fed funds target was lowered SEVEN times, from 4.5% to 1% (www.federalreserve.gov...). And of course, this does not describe all of the actions the Fed took in the markets. If you consider all of these actions (www.forbes.com/reuters...), it is pretty clear that without an underlying contracting in M2, there would have been a much more dramatic increase in the money supply over the last year.
Raising rates feeds the supply without much affecting the demand. Keynes had it backwards.
<Monetary inflation is the result of the creation of Fiat Money out of thin air.<
Money comes from the loan and is representative of the debt. The debt is backed by collateral. Money is not created out of thin air.
>Monetary inflation ALWAYS results into a price inflation whatever the level of interest rates is...history shows this over and over again: Weimar, Zimbabwe, the Civil war in the USA, the american independence,<...
Yes, but you have to understand what money really is before you can intelligently comment on the supply.
On Oct 29 11:19 AM Chris B wrote:
> But wouldn't you agree that more money is loaned (or supplied) at
> low interest rates than at high interest rates in line with the law
> of supply and demand?
When a commodity like money is strictly controlled by the vendor, the price has little effect on the demand. The problem is the money SUPPLY is controlled by the price. Higher rates encourage lenders to lend. Bank profits are the basis for their lending activities, and it is the lending activities that create money, and not the printing as is strongly suggested by Keynesian nonsense.
> If I offered you the chance to borrow $1 million at 2% interest,
> would you take it? Um... yes! You'd take the cash and find a way
> to earn 3% on it, generating $100k profit per year. How about at
> 10%?
With the supply being so strongly influenced by the price, the inflation rate will move with the base rate, and so when the base rate is at 10% there are so many more opportunities for 11% gain than there are for 3% gain when the base is at 2%.
> That said, the majority of surveyed economists agree that when the
> government creates too much money, inflation can occur.
And that is the problem. Economists almost always think of money as a creation of the central bank or the government. Money is a creation of the banking system, and the central bank is an addendum to the system which has very little direct impact on the system. Basically, most economists have a very vague understanding as to how money becomes money.
> In the US, risk aversion and big losses among banks have curtailed
> lending more than 10% interest rates ever could.
And the losses started by the Fed declaring a reduction on the base interest rate.
> This is deflationary.
Yup!
> Yet, the govt. is creating money like crazy (bailouts, "stimulus"
> checks) and dropping overnight lending rates to 1%, which is inflationary.
But as the article is trying to tell you, IT HAS NONE OF THE DESIRED EFFECT!!!
> Whether or not foreign investors flee the dollar
> will in part be determined by whether they have less risky alternatives.
But it is more determined by the relative interest rates!
Again, raising rates is not done by putting a new number on a board. It's done through open market actions, where the central bank reduces or increases the amount of money available in a specific market, which causes a change in the cost of that money (interest rate). This subsequently has impacts on other money markets as the banks compete for profits. Keynes has little to do with it.
"When a commodity like money is strictly controlled by the vendor, the price has little effect on the demand."
Nonsense. Borrowers base investment decisions on profitability. The price (cost) of money impacts profitability. 'Nuff said?
"The problem is the money SUPPLY is controlled by the price. Higher rates encourage lenders to lend."
And discourage borrowers from borrowing. Money operates in markets, just like everything else. No problem here.
"Bank profits are the basis for their lending activities, and it is the lending activities that create money, and not the printing as is strongly suggested by Keynesian nonsense."
You are seriously missing half the story, and throw in another worthless attack on Keynesian theory. Are you seriously saying that the central bank can't affect the money supply? Are you saying that the Fed's open market actions under Volcker had no effect on the money supply? Are you trying to say that if the federal government flooded the banking system with cash that it would have no impact on the money supply?
"And the losses started by the Fed declaring a reduction on the base interest rate."
Non sequitur.
The overnight rate is a new number on the board. That is the rate that banks pay to each other and is simply declared by the Fed because the Fed runs the clearing house of interbank accounts. What you are talking about is the securities rate that the Treasury sells to the banks. What you should note is that right now, theses securities are getting rates from the banks that is less than the rates that the Fed is charging the banks. That is because money is a creation of the local bank and not a creation of the central bank.
> Borrowers base investment decisions on profitability. The price (cost) of money impacts profitability. <
But profitability is not on the nominal rate, but on the real rate. The real rate move inversely to the nominal rate.
> Are you saying that the Fed's open market actions under Volcker had no effect on the money supply? <
I am saying that the effect is inverse to intended. While the Fed is trying to loosen money supply, the effective money supply has in fact been tightening.
>Non sequitur.<
Yes it does follow! When the elites of the economic world have no comprehension of what money is and where it comes from, they will make a mess of things/
Absolutely wrong. The overnight lending rate IS the federal funds rate, and it works EXACTLY as I described; the Fed sets a target, and implements open market actions designed to move the market rate to the target. This in turn impacts (to a greater or lesser degree) other rates in the market.
"What you are talking about is the securities rate that the Treasury sells to the banks."
Not sure what you're talking about here.
"But profitability is not on the nominal rate, but on the real rate. The real rate move inversely to the nominal rate."
What exactly do you think the "real" rate is? Seems to me that the real rate is the nominal interest rate plus inflation. The real rate cannot move inversely to the nominal rate. Again, think about it. Banks raise their nominal interest rates. Are borrowers more or less likely to borrow?
"I am saying that the effect is inverse to intended. While the Fed is trying to loosen money supply, the effective money supply has in fact been tightening."
Recalling your attacks on Keynesian theory, it strikes me that you're a monetarist who doesn't understand your own arguments. Your response to my question about Volcker's Fed's actions is that "the effect is inverse to intended," when clearly the Fed's actions from 1980-82 had the exactly intended effect, which was a dramatic reduction in the growth of the money supply. I don't think Friedman thought that Fed action was negatively correlated, but rather that it had marginal effectiveness.
"Yes it does follow!"
The losses did not begin when the Fed cut rates, and were certainly not due to the cuts in rates. The Fed first cut rates this time around in September 07. This was after the sub-prime mortgage meltdown began. It was the cascading failures of these mortgages, not the action of the Fed, that precipitated the crisis we are in now.
"When the elites of the economic world have no comprehension of what money is and where it comes from, they will make a mess of things."
Pot, meet kettle.
The overnight rate is the interbank rate and is simply declared by the Fed. There is no market force on this rate. The federal fund rate is the rate garnered by the fed when it sells securities to get money and has no impact on the interbank rate that the fed simply charges to the local bank's account.
>The real rate cannot move inversely to the nominal rate.<
This notion is proven wrong over and over and over. www.applet-magic.com/d...
>it strikes me that you're a monetarist who doesn't understand your own arguments.<
Don't try and categorize me. It will only confuse you.
> This was after the sub-prime mortgage meltdown began. <
Can you backup that statement. I see the rate cut as being the initiator of the meltdown.
"The overnight rate is the interbank rate and is simply declared by the Fed."
Again, this IS the federal funds rate: "The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight." (www.federalreserve.gov...)
"There is no market force on this rate."
And again, the Fed sets a TARGET rate, and then uses open market operations to attempt to push the actual rate to the target.
"The federal fund rate is the rate garnered by the fed when it sells securities to get money and has no impact on the interbank rate that the fed simply charges to the local bank's account."
No, not at all - this is completely separate. The Fed buys or sells Treasuries at market rates to increase or decrease the amount of money in the system. The change in the money supply leads to a change in interest rates (the cost of money).
">The real rate cannot move inversely to the nominal rate.<
This notion is proven wrong over and over and over. applet-magic.com/d..."
Please explain HOW you think the real rate is inversely impacted by changes in the nominal rate. I don't think there's anything in the link you provided that backs your assertion. What it shows is a dramatic deflationary environment, at a time when national output was slowing at an unprecedented rate, which increased risk aversion in lenders. It does not show any causation between lowering rates and rising real rates.
"Can you backup that statement. I see the rate cut as being the initiator of the meltdown."
Sure. First rate cut: 9/18/07. See this nice wikipedia page for a timeline of events, which includes New Century Financial's April bankruptcy filing, and the beginning of the appearance of the cascade of losses in August.
Does your bank target what interest rate it is going to credit your account with at month end??? It simply sets the rate and credits your account! It does not negotiate with you. It simply does it! The banks bank does the same to the overnight accounts of the member institutions! The overnight rate and the Federal Funds rate are two completely different things, and your comprehension of these things is very superficial.
> It does not show any causation between lowering rates and rising real rates. <
Correlation is factual. Causation is the interpretation of the facts. You cannot prove causation of any sort, but can only provide theoretical explanation.
What is shown is that as nominal rates fell, real negative rates went through the roof. You can also look at Japan's march into deflation last decade.
As I have said, rate cuts discourage lenders from lending, and thereby shrinks the money supply and causes deflation.
> New Century Financial's April bankruptcy filing<
The failure of a single company does not cause system wide panic. It does not cause meltdown of entire market sectors. Only cash contraction can do this, and there was no panic or meltdown until the Fed cut rates in September. Two weeks after every Fed cut, there is another meltdown of some markets.
Superficial, eh?
I quoted a description of the federal funds rate directly from the Fed's website. Here's the quote again, in case you missed it:
"The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight." (www.federalreserve.gov...)
Read it again. Do you comprehend the words? If you bothered to follow the link and actually read what the FOMC does, you'd learn that what the Fed sets is a TARGET. Look at the table on that page; it's called "INTENDED federal funds rate" (emphasis added). What good would it do for the fed to set the actual rate if it's not at market equilibrium (which it almost never is)? As a point of fact, the recent change in the target federal funds rate had very little effect, as the effective federal funds rate, as tracked by the NY Fed, has been below 1% for some time.
Ahh, found a link that should bring you to your senses. It's a chart from the NY Fed titled "Federal Funds Rate," showing the TARGET rate and the DAILY EFFECTIVE RATE. Since I've already established that the federal funds rate IS the overnight lending rate, you'll see that you're completely wrong here. Not that I expect you to admit it.
"Correlation is factual. Causation is the interpretation of the facts."
Geez. Look causation up in the dictionary. It's really very simple, and has nothing to do with interpretation. Determining causation is often difficult; that was my point.
"What is shown is that as nominal rates fell, real negative rates went through the roof. You can also look at Japan's march into deflation last decade."
Again, you're acting as if the deflationary environment had nothing to with anything, and you're also taking about two of the most extreme negative markets of the last 80 years, where massive systemic failures occurred. What about all of the years in between, where there was no such inverse correlation between nominal and real interest rates?
"As I have said, rate cuts discourage lenders from lending, and thereby shrinks the money supply and causes deflation."
You're making two large errors here. One is completely discounting the demand side of the equation. Second is a complete misunderstanding of how lending works. Lending markets are like any other; the players have the same motives and the same types of decisions to make. If the federal funds rate is lowered because the fed is injecting money into that market, the cost of money to the banks goes down. If this were the end of the story, the banks would lend much more, because their profit margin has increased, enabling them to take on somewhat riskier loans. Because lending is competitive, price competition will reduce rates to a new equilibrium with lower rates and somewhat more lending.
This is really basic micro stuff we're talking about here. Do you have any economics background at all?
"The failure of a single company does not cause system wide panic."
When the history is written, I think the odds are pretty good that the failure of Lehman Brothers will be identified as the catalyst that brought about the worldwide panic.
"Only cash contraction can [cause meltdown of entire market sectors]..."
Really? Have you not been paying attention to the whole CDS story? Cash contraction is not a CAUSE here. It's a result. As the banks have deleveraged, which has been happening over the course of many months but accelerated in the last two months, M3 has been decreasing. This has been happening not because of the fed's interest rates, but because of a realization that the risks that these banks took on were far more dangerous than previously understood, and that they needed to raise their capital to offset potential losses. The fear of those losses reached a tipping point with Lehman's failure, and we started a race for the bottom.
"...and there was no panic or meltdown until the Fed cut rates in September."
Huh. The S&P 500 was at 1560 or so last October. By September 11th it was 1250 (down 20%). It fell 4.7% on the day Lehman went bankrupt. It fell 4.7% two days later, when the government took over AIG. It rose 8.5% over the next two days, when the Fed first cut rates and when Paulson unveiled "The Plan." The market was fairly stable the following week, and then the House killed The Plan. Then all hell started breaking loose. The IMF issued it's worst forecast ever. The Fed and Treasury started throwing money at anything that moved. Foreign governments started nationalizing banks.
You're trying to tell me this was all because the Federal Reserve lowered the target federal funds rate from 5.25% to 4.75%?
Talk about superficial.
"Two weeks after every Fed cut, there is another meltdown of some markets."
There is so little evidence to back this assertion that's it's not worth responding to.
How do you suppose that any negotiation is possible? Checks and wire transfers must be cleared through the interbank accounts. These accounts will fluctuate daily regardless what any institution does or wants done. Only public activity affects these accounts, and the interest charged and paid is simply declared by the Fed.
If you feel that your bank isn’t giving your savings account sufficient interest, you can threaten to go to another bank. No such option is available for the interbank accounts.
Separate securities might be negotiated back and forth to feed the active accounts, but the interest on the active accounts is simply declared. The fact is that the declared overnight rate is different from the Federal Funds rate. One is declared, and one is negotiated.
> Determining causation is often difficult; that was my point.<
Proving causation is impossible. Your point was to dismiss correlation that fails to support your mindset.
>Again, you're acting as if the deflationary environment had nothing to with anything,
I am telling you that deflation is a symptom of money supply tactics and nothing else.
> What about all of the years in between, where there was no such inverse correlation between nominal and real interest rates?
When was this. In the 70s, nominal rates soared and real rates went negative. Every time nominal rates are adjusted, the real rates move in the opposite direction.
>One is completely discounting the demand side of the equation.
And I say that Keynes completely discounted the supply side of the equation, and further, failed to regard the real world in the formulation of his theories.
>If the federal funds rate is lowered because the fed is injecting money into that market,
The fed does not create money. When a bank creates a loan, its equity is unchanged. It gets an interest bearing asset (lien) and gives out liability in the form of a draft. If the draft is deposited to another bank, the liability is with that bank. Regardless what bank it goes to, the liability is always to the customer. If the customer wants a tangible to hold on the liability, the bank can borrow the paper coupons from the fed, but this process is an addendum to the bank/cash system, and in no way a foundation to it. Money, regardless how you might regard it, has absolutely no bearing to the society until it is leant out by the local bank. A bank with $10,000 in bills can create 100,000 in loans, and does so with no problem.
>This is really basic micro stuff we're talking about here. Do you have any economics background at all?
We are discussing macro economics. Micro principles are not applicable to the macro economy.
>This has been happening not because of the fed's interest rates, but because of....
> Determining causation is often difficult; that was my point.<
Could you link the timetable you are referring to again? I know you meant to 2nd last post, but it didn’t show up.
>The Fed and Treasury started throwing money at anything that moved.<
Why should they do that if cash contraction is not a problem? Why continue to do so when it doesn’t seem to have any lasting effect?
The cash contraction is caused by the fact that cutting interest rates discourage lenders from lending, and no amount fed activity will encourage banks to lend again until the Fed hikes rates again. Again I suggest you look at the experience of Japan.
"Open Market Operations"
"Open market operations--purchases and sales of U.S. Treasury and federal agency securities--are the Federal Reserve's principal tool for implementing monetary policy. The short-term objective for open market operations is specified by the Federal Open Market Committee (FOMC). This objective can be a desired quantity of reserves or a desired price (the federal funds rate). The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.
"The Federal Reserve's objective for open market operations has varied over the years. During the 1980s, the focus gradually shifted toward attaining a specified level of the federal funds rate, a process that was largely complete by the end of the decade. Beginning in 1994, the FOMC began announcing changes in its policy stance, and in 1995 it began to explicitly state its target level for the federal funds rate. Since February 2000, the statement issued by the FOMC shortly after each of its meetings usually has included the Committee's assessment of the risks to the attainment of its long-run goals of price stability and sustainable economic growth.
"For more information on open market operations, see the article in the Federal Reserve Bulletin (102 KB PDF). [www.federalreserve.gov...]
From that article:
"Open market operations are the Federal Reserve’s principal tool for implementing monetary policy. These purchases and sales of U.S. Treasury and federal agency securities largely determine the federal
funds rate—the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight...
"The market in which the lending of Federal Reserve balances takes place is the federal funds market, and the interest rate at which the loan is made is the federal funds rate. Federal funds lending is not collateralized; therefore, different depository institutions pay different rates for loans depending on their creditworthiness. Depository institutions can arrange transactions directly between themselves, or for large transactions they can use a federal funds broker. Typically, the term ‘‘federal funds rate’’ refers to the rate at which the most creditworthy institutions borrow and lend balances in the brokered market."
Once again, slowly:
(a) the federal funds rate IS the overnight lending rate;
(b) the market determines the ACTUAL federal funds rate;
(c) the Fed declares a TARGET for the federal funds rate;
(d) the FOMC conducts open market operations to attempt to move the effective federal funds rate to the target.
"How do you suppose that any negotiation is possible? Checks and wire transfers must be cleared through the interbank accounts. These accounts will fluctuate daily regardless what any institution does or wants done. Only public activity affects these accounts, and the interest charged and paid is simply declared by the Fed."
Now it sounds like you're confusing the federal funds rate with the discount rate. But clearly, you should go do some reading and then come back.
"Proving causation is impossible. Your point was to dismiss correlation that fails to support your mindset."
Proving causation is impossible? Are you trying to move into philosophy now? If I run over you with my car, is it possible to prove the cause of your injuries? Of course it is.
Now, as for dismissing correlation that fails to support one's mindset, you're the one who is ignoring decades of evidence that belies your assertion. From the last 80 years of data, you pulled out 5% that appears to support your assertion, ignoring the remaining 95%. Even your own cited page states: “the nominal interest rate was declining over the course of the economic decline from 1929 to 1933 but BECAUSE THE RATE OF INFLATION WAS NEGATIVE the real interest rate was much higher than the nominal interest rate [emphasis added]. YOUR OWN SOURCE doesn’t claim an inverse correlation between nominal interest rates and real interest rates.
But let’s get more basic. Do you know the definition of real interest rates? It’s the nominal rate plus inflation. That’s it! So how could there possibly be an inverse correlation?
By the way, here’s that fed chart I mentioned last time: www.newyorkfed.org/cha.../ . On this page (www.ny.frb.org/markets...) that links to it you will find this text: “By trading government securities, the New York Fed affects the federal funds rate, which is the interest rate at which depository institutions lend balances to each other overnight.” Are you still going to insist that you’re right, without citing a single source, when I now have both the main fed and the NY fed websites stating that THE FEDERAL FUNDS RATE IS THE OVERNIGHT LENDING RATE?
“I am telling you that deflation is a symptom of money supply tactics and nothing else.”
What are “money supply tactics”? Deflation occurs when the money supply doesn’t grow fast enough or shrinks, which is what has been happening as the banks deleverage.
“In the 70s, nominal rates soared and real rates went negative.”
In the 1970s, we had wage and price controls and oil shocks, both of which had significant impacts on inflation. High inflation is what caused the real interest rate to become negative.
“Every time nominal rates are adjusted, the real rates move in the opposite direction.”
You’re making a fool of yourself. You should just stop.
“The fed does not create money.”
Of course it does. That money created by the fed is a fraction of M3 does not mean the fed doesn’t create money.
“We are discussing macro economics. Micro principles are not applicable to the macro economy.”
Actually, what I was talking about was the functioning and interconnection of a couple of very specific money markets. Certainly microeconomics. Back to the question: do you have any economics training at all?
The timetable link is there. I’m not surprised you couldn’t find it, however. en.wikipedia.org/wiki/...
“Why should [the fed and Treasury throw money at everything] if cash contraction is not a problem?”
I never said the money supply was not shrinking. I’m saying you have no clue as to the reasons for it.
“The cash contraction is caused by the fact that cutting interest rates discourage lenders from lending, and no amount fed activity will encourage banks to lend again until the Fed hikes rates again.”
You are apparently an ignoramus. You present no evidence to back your assertions, you ignore evidence handed to you that refutes your beliefs, and yet you are steadfast. Why am I wasting my time?
“Again I suggest you look at the experience of Japan.”
I’m just going to give you a quick quote on this:
“The government attempted to offset the stronger yen by drastically easing monetary policy between January 1986 and February 1987. During this period, the Bank of Japan (BOJ) cut the discount rate in half from 5 percent to 2.5 percent. Following the economic stimulus, asset prices in the real estate and stock markets inflated, creating one of the biggest financial bubbles in history. The government responded by tightening monetary policy, raising rates five times, to 6 percent in 1989 and 1990. After these increases, the market collapsed.” [mises.org/story/1099]
Again, doesn’t follow your incredibly incorrect theory.
It isn't claimed, but it is clearly displayed.
>The government responded by tightening monetary policy, raising rates five times, to 6 percent in 1989 and 1990<
The rates went down to virtual zero WHILE the markets were collapsing. And now you're going to claim a time lag. ALL economic activity is dependent on today's ACTUAL condition coupled to FUTURE expectation. The Keynesian notion that the economy is "sticky" is lame excuse to address the fact that his prescriptions just do not work.
No, actually, it's not. What's shown is deflation. Once again, with feeling, since the real interest rate equals the nominal interest rate plus inflation, how exactly would the real interest rate and the nominal interest rate be inversely correlated?
"The [Japanese] rates went down to virtual zero WHILE the [Japanese] markets were collapsing."
Naturally, of course, unsurprisingly, you're wrong yet again. Please look at the data. The Nikkei fell more than 60 percent—from a high of 40,000 at the end of 1989 to under 15,000 by 1992. Japan raised the discount rate from 2.5% in the beginning of 1989 to 6% at the end of 1990. Starting in mid 1991, when the market had already lost 40% from its peak, the discount rate was lowered several times over the next 5 years. When the market reached its 8/92 bottom, more than 60% off the peak, the discount rate was still 3.25%. The rate continued to be cut, to 0.5% in 1995 and eventually to 0.1% in 2001 - not at all WHILE the markets were collapsing. Most of the collapse occurred before the discount rate was cut ONCE.
Of course, it's necessary to consider the nature of the savings patterns of the Japanese people vs. the American people, but that's beyond my patience to explain.
When interest rates rise, lenders are encouraged to lend, and thereby the cash supply is increased and inflation is increased and so the real rates are brought low. When interest rates drop, lenders are discouraged from lending, and thereby the cash supply is decreased and inflation is decreased and so the real rates are pushed higher.
>The Nikkei fell more than 60 percent—from a high of 40,000 at the end of 1989 to under 15,000 by 1992. <
The exchange rate is not a good indicator of the inflation rate at all. The money supply was contracting, was it not? Yet the interest rates were falling, making Japan less desirable to foreign investors, and so the exchange rates fell off even though the cash contraction was diving into deflation.
> When the market reached its 8/92 bottom, more than 60% off the peak, the discount rate was still 3.25%<
Where are you getting that info? I remember when the Nikkei crash was THE big news story, it was also stated that interest rates were already virtually zero and couldn't be lowered anymore. Even that negative interest was being charged to savings accounts.
"When interest rates rise, lenders are encouraged to lend, and thereby the cash supply is increased and inflation is increased and so the real rates are brought low."
Except, of course, there are fewer borrowers at higher interest rates. Once again you ignore the demand side of the equation. But that's a minor matter, since you're ignoring the market pricing mechanism as well. Lending rates are determined through competition. And of course lenders also factor expected inflation into their interest rates.
And of course, what we're talking about are not rates between banks and borrowers, but rates between the banks and the Fed. This is in a very real sense the cost of money to the banks. Lower the cost of money and the banks have a greater incentive to lend, because the profits are larger. Given time, profits will be squeezed out and new equilibriums will be reached across the lending markets at lower interest rates.
Seriously, this isn't rocket science.
"The exchange rate is not a good indicator of the inflation rate at all."
Who said anything about exchange rates? Do you not know what the Nikkei is?
"The money supply was contracting, was it not?"
Strictly speaking, no, M1 was not contracting at all. Was M2 or M3 contracting? Of course it was. Was it because of interest rate changes? Not at all.
"Yet the interest rates were falling, making Japan less desirable to foreign investors, and so the exchange rates fell off even though the cash contraction was diving into deflation."
Shift your arguments all you want. The highest central bank interest rates persisted more than halfway through the market collapse.
"Where are you getting that info?"
So you really have no clue at all, then. Nikkei is from Yahoo finance, the rates of the BOJ are easy to find.
"I remember when the Nikkei crash was THE big news story, it was also stated that interest rates were already virtually zero and couldn't be lowered anymore."
So your beliefs are based on your obviously fuzzy recollections of something that happened more than 15 years ago. Now I understand completely. Good bye.
I think it might be found that the reserve requirements were drastically changed on the local banks in 90. Obviously there was a sudden cash contraction, and the rate cutting since has not improved anything.
>Strictly speaking, no, M1 was not contracting at all.<
If the active money supply was not contracting, then why would the fed think that money infusion should be indicated. And... money IS active money. Money that has not changed hands recently has absolutely no bearing on the health of the economy. Money's value is only in the exchange, and it has no value or economic interest without an exchange.
Everything depends on the amount of credit in the economy. If the amount of credit in the economy is much more than GDP (as historical evidence shows) you start to have monetary inflation, which have to be fought by raising interest rates. If there is not enough credit in the economy, than raising interest rates would be useless and you start to have transactional inflation, i.e. businesses must recoup expensive credit by raising prices to consumers.
Having low interest rates leads to too much credit, which kills the economy in the long run as the case with Iceland and soon US.. This will give you things like Credit crunch. In US, for every $1 in currency, there is $12 of credit. Thus, you must charge very low interest rate to keep this system working, but this then generates even more credit, which basically is like printing money.. This is what US is doing right now.. This will obviously lead to hyperinflation in US sooner or later..