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Things Are What They Seem

February 22, 2010

There has been a lot of very passionate disagreement from people who I assume want to be as literally accurate as possible saying that the Fed’s recent increase in the discount rate was nothing but a technical move and did not signal any sort of movement in a different measure of “the” interest rate (Fed Funds), nor was it of contractionary intent.

On a purely technical level, these people are right. However, as many very smart people have pointed out in their scholarly work, the most important effect that monetary policy has is its effect on expectations…and a growing expectation is that the Fed is eager to begin the process of returning to more “traditional” central banking (or, beginning its exit strategy).

If people believe that a policy action signals that the future path of policy will be tighter, then the effect of the policy action is contractionary…which is exactly what markets expect:

November 2010-dated fed funds futures contracts, reflecting market expectations for the overnight rate following the early November meeting of the Federal Open Market Committee, saw prices fall by 5 basis points in electronic trading late Thursday after the announcement.

The price move indicated that traders now see a 100% chance for the Fed to hike its benchmark rate to 0.5% by contract expiration, with a 16% chance that the rate could rise to 0.75%.

At the close of trading Thursday, the November contract priced in a 96% chance for a rise in the fed funds rate.

Any amount of rationalizing after the fact is useless unless the Fed credibly commits to a more expansionary trajectory for monetary policy, which they have not shown interest in. Indeed, New York Fed president William Dudley claims that the Federal Reserve is committed to “keeping rates low for an extended period.” That’s all well and good, but low rates for a long time mean failure to return to the original trajectory of nominal spending. Who else has had “low rates for an extended period”? Oh yea, Japan. Australia has been raising rates since October, and they haven’t had a recession since the early 90’s…which country would you rather be?

In 2006, Bernanke is famously quoted as saying:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

I wonder what Milton Freidman would have to say

Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.
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After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.

Unfortunately, since no magical beings seem to be willing to lend out their crystal balls (blame the recession?), markets are the best proxy that we have as to the aggregate effects of monetary policy.

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