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Subject:  As I long suspected Date:  1/30/2013  9:28 AM
Author:  AdvocatusDiaboli Number:  414670 of 479893

Over recent years, I have increasingly come to the conclusion that many modern economists spend too much time with their models and forget that it is critical to understand how those relate to what's happening in the real world.
In fact, many seem completely oblivious about basic economic phenomena.

Today John B. Taylor, the father of the "Taylor Rule" (which regards monetary policy) has demonstrated in spectacular fashion that he has actually no idea what the Fed does when it does monetary policy. Or he just doesn't understand it. Or he doesn't understand the bond market. Or maybe he was just on LSD when he wrote this WSJ editorial.

So if investors are told by the Fed that the short-term rate is going to be close to zero in the future, then they will bid down the yield on the long-term bond. The forward guidance keeps the long-term rate low and tends to prevent it from rising. Effectively the Fed is imposing an interest-rate ceiling on the longer-term market by saying it will keep the short rate unusually low.

The perverse effect comes when this ceiling is below what would be the equilibrium between borrowers and lenders who normally participate in that market. While borrowers might like a near-zero rate, there is little incentive for lenders to extend credit at that rate.

This is much like the effect of a price ceiling in a rental market where landlords reduce the supply of rental housing. Here lenders supply less credit at the lower rate. The decline in credit availability reduces aggregate demand, which tends to increase unemployment, a classic unintended consequence of the policy.

THAT is just depressing.

Here is how monetary policy works: The Fed buys treasury bonds. The price of treasury bonds rises. The yield falls. Other investors are forced into buying other bonds and other asset classes, increasing demand for those bonds and assets whose yield also falls.

Unlike what Professor Taylor seems to think, monetary policy does not act like a price control on debt (other than trea