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.http://online.wsj.com/article/SB1000142412788732337520457826...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 treasuries). Nobody's keeping a bank from lending money to a company at 5, 10, 15, 20, 50%. If banks aren't lending to a debtor, it's because they don't want to lend money to that debtor at a price that is acceptable to the debtor.There is no conceivable theoretical reason why Fed purchases of treasury bonds might keep creditors from lending money to borrowers at whatever price the parties might agree on.The only thing the Fed does is make alternative investments such as treasury bonds less attractive.John Taylor is one of the most influential voices in modern monetary policy and he lacks the basic understanding of how the credit system works.We're doomed, aren't we?
Oh, and:Thomson Reuters lists Taylor among the 'citation laureates' who are likely future winners of the Nobel Prize in Economics.http://en.wikipedia.org/wiki/John_B._Taylor
...Or [Taylor] he was just on LSD when he wrote this WSJ editorial...THAT is just depressing... We're doomed, aren't we?AD,I vote for "he was on LSD" - and yes, we're doomed.I partially disagree with this assertion, though: The only thing the Fed does is make alternative investments such as treasury bonds less attractive.Treasuries are perhaps less attractive to many/most investors due to the Fed's driving up the prices of same. However, for the primary dealer banks who buy from the US Treasury at par and flip them to the Fed at a guaranteed premium, bonds are as attractive as ever.Who wouldn't love to be the middleman selling a product you didn't have to produce to a buyer with unlimited funds?Anyway - yes, we're doomed.Ph.D.'s are common. Common sense is rare (someone else said that recently on the board).;-)
The only thing the Fed does is make alternative investments such as treasury bonds less attractive.Don't forget about the Fed's activity in MBS (mortgage backed securities) to shore up the housing market by keeping mortgage interest rates low. The Fed buys only Agency (Fannie Mae and Freddie Mac) bonds. Here's a good site to watch that activity.http://www.mortgagenewsdaily.com
Right on AD.The same argument has been made for the Fed not cutting the rate paid on excess reserves (IOER) to zero.The money market fund industry says that they couldn't operate with lower short term rates, so companies would not be able to issue commercial paper, so the world would stop.But as in the case with long term rates, there'd be nothing to stop companies paying whatever the market rate became, even if it didn't decline much.Surely cutting IOER to zero would be a much neater stimulus and easier to exit from than QE.
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