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What Was The Fed Thinking?

it seems to me that much of the discussion of recent and current monetary policy is focused in the wrong place.  It's not at all about interest rates - it's about the price level.

The goal of the Fed's actions in late 2008 was not to drive interest rates to zero.  It was to prevent a contraction in the money supply caused by the rapid reduction of activity by the banking sector.  A reduction in the money supply would tend to lead to an increase in the value of money, or delation.  Experience and theory agree that any significant or sustained deflation is enormously damaging to an economy, because normal incentives are turned on end. 

So the Fed moved quickly and decisively to prevent the money supply contraction caused by the collapse of bank leverage, expanding its balance sheet and the monetary base in an unprecedent manner.  Clearly, the moves were proper, as the price level has remained fairly stable for the last 18 months.  

Naturally, the Fed's actions also pushed interest rates to near-zero.  This also is appropriate policy to combat a contraction the size we saw in late 2008, but having low interest rates is not the goal here.  Stabilizing the money supply is. 

Moving forward, I don't think the Fed will be looking to increase interest rates, at just the right time and by just the right amoount, to moderate a potentially inflationary expansion.  Instead, the Fed will be looking for stability in the money supply, reducing its balance sheet as bank lending eventually increases.  Without increased bank lending and the consequent increase in M2, inflation is just not a concern, even with a modestly expanding economy.

Generally speaking, all of these things will tend to occur at about the same time; the economy is not likely to grow very quickly without increased bank lending, which would cause the money supply to increase, which would cause inflation.  But it's useful to look at the right trigger for Fed action: bank lending.


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