If I Were Fed Chairman

The Federal Reserve Open Market Committee doesn’t seem to know what to do.  Just six months ago, it told us it wanted to continue to raise its rate target in 2019.  Only weeks later, it wanted to be “patient” with raising rates.  Now it’s trial ballooning rate cuts.  Its program to get interest rates back to something resembling normal seems to have been aborted before it got even halfway there.  The FOMC needs new ideas.  

If I were in Federal Reserve Chairman Jerome Powell’s shoes, I’d push for gradually widening the target band for fed funds with the idea in mind of phasing it out as the Fed’s main policy tool, to be superseded by quantitative policy. Although quantitative policy is viewed as unconventional, interest rate manipulation has deeply damaged our economy. In any case the Fed has been cutting rates for nearly forty years and the only way to continue that would be to push them below zero, which would be even more damaging.

The fundamental problem is that price signals form the neural network of a free market economy. Interest rates represent the price of credit. We forbid price manipulation in any other area of our economy, but carve out an exception in the case of interest rates. It should come as no surprise then that the credit markets have been susceptible to bubbles and busts.  For instance the dotcom bubble in the nineties, and crises like we saw in 2007–2009. Price fixing in the credit markets cuts off the signaling that would otherwise reign in excesses. It’s the financial equivalent of sticking a penny in the fuse box … you might get the current flowing again, but at the risk of burning down the house.

Not to mention that the “cure” has involved creating even more debt and kiting asset prices, with the result that the wealthy – by definition the owners of most of the assets – have grown much wealthier as the average citizen has been left behind. Judging by its effect on the political landscape, our economy is under greater threat as a result than from any bank failures.

So my new paradigm for monetary policy would involve managing the money supply by buying and selling Treasury securities – quantitative easing and tightening – without setting interest rate targets. In the US system directing the funds created would be a fiscal issue for Congress. The price of credit would be set the same way we insist on for other prices, by the free market.

Imagine you had an unlimited supply of dollars and decided you were going to buy an ETF with the ticker UST, currently trading in a two digit range. You could either specify that you’ll buy ten million shares at whatever the market price is or you could specify that you’ll buy whatever amount the market will offer at $100 a share. One way the quantity is fixed and the price is variable and the other way the price is fixed and the quantity is variable. See the difference? Both are likely to raise the price of UST, but only the second way amounts to price fixing. In the first the market still has price discovery.

The second way is even more aggressive if you publicly announce the price you’re going to buy at, and even more aggressive if you disclose the price you’re going to buy at today, next quarter and next year. This is effectively how Fed funds has evolved since Greenspan started the “transparency” kick. You’re committing potentially infinite funds to your target price and destroy the market. Hence my sticking a penny in the fuse box metaphor.

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