[jmherbener]

The claim is that Fed policy of providing bank reserves through open market operations and other asset purchases, must decrease the fed funds rate since that is the rate for trading bank reserves. How the ensuing credit expansion affects other interest rates depends on bank lending, not on Fed policy. And the interest return on longer projects in production also depend on entrepreneurial decisions to invest.

Without monetary inflation and credit expansion, banks are constrained to intermediate credit across the yield curve according to underlying factors, e.g., the intensity of savers’ time preferences for shorter v. longer lending, differences in uncertainty, etc. The resulting yield curve, then, would reflect these underlying factors.

1. With monetary inflation providing more bank reserves, banks have no constraint from savers’ time preference in creating credit across the time structure. They are not intermediating savers’ lending, but creating loans. With Fed bailout guarantees, banks tend to leverage credit creation flattening the yield curve.

When longer-term credit interest rates decline, then arbitrage opportunities exist for shifting capital funding into longer production processes until the rate of return on those projects conforms to the lower long-term interest rates.

Since the Fed cannot control but only influence these broader interest rates and rates of return, it tends to excesses in monetary policy as its initial monetary stimulus may have little effect. In this way, the Fed is the source of volatility of the yield curve slope.

2. The reason changes in underlying time preferences do not cause booms and busts is because the ensuing building up and tearing down of the capital structure is sustainable. The built-up capital structure caused by lower time preference is sustained by the greater saving-investing. The torn-down capital structure caused by higher time preference is sustained by the smaller saving-investing.

The boom is set in motion by credit expansion without any additional saving-investing from people and therefore, results in a built-up capital structure that cannot be sustained and must be torn down to match people’s underlying time preference.