The Fed

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    I just got off the phone with my friend who is a commodities trader and who identifies with the Austrian School, and he tried explaining a theory about the Fed that I don’t quite understand, and which seems to fly in the face of the evidence. I’m hoping Professor Herbener is familiar with it and can untangle it.

    He said that the Fed isn’t really in control of things. That it just sees that interest rates are going up or down and tries to stay ahead of the curve by setting them accordingly. That the economy is too large for the Fed to be able to really be the Maestro. That globalization and foreign regimes have made it so. And many other things that he didn’t have time to explain. He said to look at bond markets as an example. He also kept saying, “there’s not enough demand.”

    This doesn’t seem to make sense to me given that there seems to be strong, repeated empirical evidence corroborating the ABCT.

    Is the faculty familiar with this line of argument? Is there a name in economics for theories of this type? What are we to make of them?

    Thank you


    The Fed can directly manipulate bank reserves. It does so by buying securities from banks. Every other factor in the economy, the Fed only indirectly controls and the more remote the connection between bank reserves and the other factor, the less control the Fed has and the more control over the factor in the hands of others.

    By increasing the supply of bank reserves, the Fed can push down the Federal Funds rate, which is the interest rate bank’s charge each other for over-night lending. By increasing bank reserves, the Fed gives incentives to banks to create more credit, which lowers interest rates in various credit markets. But that effect requires banks to expand their loan portfolios, which they do not have to do. Instead, they can build excess reserves, in which case the Fed expansionary policy is blunted. If banks do expand credit in response to expansionary Fed policy, then the lower interest rates and increased demand (by borrowers using the newly created credit) for assets drives up asset prices. But if people are reluctant to borrow, then interest rates will collapse without much asset price inflation. And so on, the effect of Fed policy generates effects on the real economy only through people’s reaction to it. Since their reaction can vary, the effectiveness of Fed policy can likewise vary.

    The extreme positions that the Fed has no effect on the economy and that the Fed controls the economy are both certainly mistaken. Sometimes the Fed seems to lead events and sometimes it seems to follow them. While the pattern of a boom-bust cycle set in motion by monetary inflation and credit expansion repeats qualitatively, quantitatively the effects of Fed policy vary widely depending on the circumstances. For example, a much more modest increase in bank reserves during 2003-2007 ignited the housing-bubble boom, but a much more expansive increase in bank reserves during 2009-2014 has not generate a commensurately larger boom.

    The greater effectiveness of monetary policy during the boom compared to the bust is well known insight, even in the mainstream:


    Did derivatives play any role at all in leading to the financial crisis?


    Asset price inflation during the boom is driven by Fed induced monetary inflation and credit expansion. So with or without modern derivatives, we get the boom-bust cycle, e.g. the roaring twenties followed by the Great Depression.

    Moreover, derivatives are ancient, not modern and yet, business cycles arise in the 18th and 19th century.

    Finally, the take-off of financial markets occurred during the 19th century, coincident with the greater centralization of monetary inflation and credit expansion and greater regulatory interference of financial markets by the government. Scroll down to the charts starting on page 52:


    Is my reasoning correct that the risks taken in the derivatives markets wouldn’t have been taken if it weren’t for the credit expansion that the Fed caused?

    Was there a greater level of risk taken in the derivatives markets than previously?


    Why does the Fed believe it needs to at times raise rates to slow economic growth?


    Fed officials often think of the macro-economy in terms of the Phillip’s Curve trade-off between unemployment and inflation. (Officially, they refer to their “dual mandate” to fight both unemployment and inflation.) When an expansion progresses to the point at which labor markets tighten, the fear of cost-push inflation arises.

    Here is Janet Yellen in 2015 on Fed tightening:


    Is it true that the Fed looks at 30 day, 90 day, and 1 yr T-bills to determine whether or not to raise rates?

    What should one make of the claim that the Fed simply responds to rises or falls in the market in order to determine whether to raise or cut rates?

    Is this analysis correct:(?)

    When rates on these bills are low, thats because the economy is underperforming and people flock to treasuries for safety, but when they are high, this indicates better economic conditions, as the government has to offer more interest to attract investors away from higher return investments people feel more comfortable making.

    Also, why have we not seen the crisis that was widely predicted when the Fed raised rates? How can one tell whether or not the rate increase was due to economic recovery?


    Please ignore and feel free to delete this comment. Dr. Woods asked me to see if I could post in forums.


    Also, why can a bubble finance system theoretically not be kept in place indefinitely? What would cause the bubble to burst other than the Fed raising rates?


    For asset-price inflation to continue, investors must pour more and more funding into projects less-and-less likely to pay off in terms of the previous elevated rates of return. Investors with superior foresight recognize this fact first and pull out. When they pull out prices begin to soften or rise less vigorously leading other investors to pull out and so on.

    No outsider knows what metrics the Fed actually uses in setting monetary policy.

    Here is Janet Yellen on recent monetary policy. She has tended to emphasize the labor market and price inflation as guides and not interest rates.

    Sometimes the Fed leads credit markets and sometimes it follows. It’s not unusual for the Fed to lower its target for the FFR and have market interest rates follow downward during the boom and for market interest rates to rise at the end of the bust or beginning of recovery and then the Fed follows by raising its target. This has been the pattern since the dotcom bubble burst.

    Market interest rates have remained low mainly because of suppressed demand for credit. This cause can be distinguished from the other possible cause of low rates, which is increased supply of credit, by looking at the amount of credit traded. If it is lower, then smaller demand is the cause. If it is higher, then larger supply is the cause. When rates begin to move up again, the cause is either an increased demand for credit or reduced supply. Clearly, demand is increasing which indicates, if not a recovery, at least a normalization of credit markets.

    We have not seen any ill effects of the Fed raising its target rate because it is following market rates upward as they normalize.


    How is it possible to have a recovery or normalization of credit markets in light of the Obama administration and the Fed’s polices that haven’t changed at all?

    My understanding was that we’re experiencing a false inflationary boom…are we in fact seeing a real recovery?


    By “normalize” I don’t mean “move to a market-determined level.” That would be impossible, or at least impossible to know, given our central-bank directed fractional-reserve banking system. What I meant was that interest rates are moving up from their recession suppressed levels toward historically normal levels. This movement is being driven by the restoration of demand for credit which has been unusually suppressed by government policies during the so-called Great Recession.

    Robert Higgs has written about this:

    Of course, the Fed never permits a genuine or pure recovery of our economy. That would necessitate elimination of monetary inflation and credit expansion altogether. So, every post-recession phase of the business cycle in our economy is a mixture of monetary-inflation, credit expansion elements (on the money supply and credit supply sides of those markets) and restoration of entrepreneurial activity (on the money demand and credit demand sides of those markets). Money demand, which skyrockets during the bust, “normalizes” during the post-bust phase and investment, which collapses during the bust, “normalizes” during the post-bust phase.

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