The FOMC: To Pause or Not to Pause?

Gerald P. Dwyer

February 2, 2023

The Federal Open Market Committee (FOMC) meets this week and will decide whether or not to raise the Federal Funds interest rate and, if so, by how much. Reports and forecasts indicate the FOMC will increase the Fed Funds rate by 1/4 percent, or 25 basis points.

Taken by itself, an increase in short-term interest rates by 25 basis points Is relatively unimportant. A change in interest rates that small is unlikely to have substantial effects on consumers’ or firms’ s borrowing or lending.

The increase, though, is part of a series of increases and those do matter. For much of 2022, the FOMC was playing catchup after misinterpreting the increase in inflation as “temporary” and small. This interpretation was in spite of the dramatic increase in M2 in 2020 by  16 percent from February to June in 2020. Absent other factors affecting the inflation rate, this suggests an increase in the level of prices in the United States by about 15 percent. This increase would of course occur over time. If households’ expectations of inflation in future years were unaffected, that would be the end of the story. While not as “temporary” or as minor as the FOMC inititially interpreted the increase in inflation, higher inflation need not be persistent.

In response to the inflation, the Federal Reserve increased the Federal Funds rate from a range of 0 to 1/4 percentage point to 4 to 4-1/4 percentage points in 2022. These increases occurred due to increases by 1/4 to 3/4 percentage points at each of the FOMC’s meetings in 2022. There were extraordinary increases of 3/4 percentage point in June, July and September.

The series of increases can be interpreted as part of a plan to raise interest rates and lower inflation rates to decrease the extraordinary inflation due to the one-off cash distributions in 2020.

These increases in the Federal Funds rate have been associated with a decrease in the inflation rate. The attached figure shows the inflation rates from January 2020 to December 2022 measured by the Consumer Price Index and the Personal Consumption Expenditures (PCE) deflator, both with and without food and energy prices removed. The figure includes commonly used measures and the FOMC’s measures of both its target – the PCE deflator – and what the Fed believes is the best indicator of underlying inflation: the PCE deflator without food and energy.

While there are differences, there is common overall behavior. After deflation in 2020, inflation returned and increased dramatically, peaking at 1.0 percent per month in March and June of 2022 for the PCE deflator with volatile food and energy prices included. These inflation rates are 12 percent per year if they were to continue for a year. Without food and energy, inflation peaked at 0.6 percent per month in June, an annual rate of 7.2 percent for a year. Since then, inflation has been noticeably lower and falling overall. While not too much should be made of any one month’s data alone, inflation fell in the second half of 2022. The inflation rate for the six months July through December 2022 (the latest data available) is 1.8 percent, which would be an annual inflation rate of about 3.6 percent. While not as low as the target average inflation rate of 2 percent, the direction of movement is correct.

Furthermore, the breakeven inflation rate on 5 and 10 year dollar-denominated and inflation-adjusted government securities  is 2.3 percent. This is roughly consistent with the Fed’s target. These rates are down from 3.5 and 3.0 percent earlier in 2022. This suggests that expectations are more or less consistent with the Federal Reserve’s stated goals.

Given the lagged effect of monetary policy on the economy, it is quite possible that the inflation rate will gradually return to the Federal Reserve’s goal and to what market participants expect without any further changes in the Federal Funds rate.

Why not increase rates more, possibly buying insurance against inflation increasing?

While inflation is moderating, signs of impending recession are common. The long-term interest rate is above the short-term rate, which has been a reliable signal of recession at least since World War II. Reports of large layoffs at large companies have been common in the Wall Street Journal. The WSJ even had an article about whether it is appropriate to lay off people by email. M2 is not given much credence as a signal by many, just as it wasn’t for the recent inflation. That said, the recent monthly declines in M2 do not suggest higher or even continuing inflation.

While the Phillips Curve is commonly invoked as a reason to induce a recession and thereby lower inflation, the fall in inflation in 2022 is evidence that a recession is unnecessary. That is in addition to the large body of theoretical arguments and empirical evidence that the Phillips Curve is not informative.

While inflation is not down to 2 percent, the direction is correct. Given uncertainties due to the unusual stimulus and the lagged effects of monetary policy, it would be prudent to hold the Federal Funds rate constant for a few months and see how the economy responds to recent policy.

Originally published at The FOMC: To Pause or Not to Pause? | AIER.

US is spending record amounts servicing its national debt – interest rate hikes add billions to the expense

Gerald P. Dwyer

Feburary 2023

Consumers and businesses aren’t the only ones feeling the pain of higher borrowing costs because of Federal Reserve rate hikes. Uncle Sam is too.

The U.S. government spent a record US$213 billion on interest payments on its debt in the fourth quarter, up $63 billion from a year earlier. Indeed, a jump of almost $30 billion on the previous quarter represents the biggest quarterly jump on record. That comes as the Fed lifted interest rates a whopping 4.25 percentage points from March through December.

As an economist, I am concerned that the effect of higher interest payments on the government’s budget is being ignored. Higher interest payments mean the federal government will either have to lower spending, raise taxes or issue more debt to service its obligations. And financing interest payments by issuing more debt could be a particularly poor choice – sooner or later, the bill will come due.

Government Interest Payments Quarterly

The national debt – the amount the federal government borrows to balance the budget – increases when spending is greater than revenue and accumulates over time. As a general rule, it increases over time because of increases in spending, revenue and the deficit. Inflation tends to increase government spending, as well as revenue and deficits. As a result, the dollar value of government debt increases in times of inflation. Debt also tends to grow as the economy gets bigger – although this is not inevitable as policymakers could choose to balance the government’s budget.

In this way, total government debt has climbed over the years – by the end of 2022 it was 10 times larger than it was in 1990. It currently stands at over $31 trillion dollars and represents more than 120% of the nation’s gross domestic product. GDP is the total annual amount of goods and services produced by a country and often is used to judge whether debt is high or low.

Since 1990, government debt has more than doubled relative to the size of the economy – indicating that servicing debt could be quite a bit more of an issue than it once was.

A decade of record-low borrowing costs

But how concerning are these numbers? After all, it is not as if the government debt has to be paid off every year.

Government borrowing has some similarities to a person paying for an expensive item with a credit card, with the actual amount due to be paid off over an extended period. Just as with purchases on credit, interest is applied – and can add to the overall outlay. The federal government is different from consumers, though – it need not pay off its debt for the foreseeable future.

In terms of interest payments, the U.S. has been fortunate in recent years. Historically low interest rates since the 2008 financial crisis have held down interest payments. And just as low interest rates encourage would-be homeowners, for example, to take out a larger mortgage, they have also made it much more attractive for the federal government to borrow money to pay for whatever Congress and the administration want to finance.

But then came 2022. Soaring inflation – which reached levels not seen in 40 years – meant an end to the days of near-zero interest rates. To restrain inflation, the Fed raised rates seven times in 2022, taking the base rate from near zero to a range of 4.25% to 4.5% at the end of 2022. The Fed raised rates a further 0.25 percentage point at its monetary policy meeting that wrapped up on Feb. 1. Projections made by Federal Board members indicate that, with future increases, rates will average 5% or more in 2023.

Not all government debt, however, carries these current higher interest rates. Just as with typical U.S. mortgages, much of the government debt bears the interest rate applied when it was taken on. The difference is, unlike homeowners, the government does not pay off its debt. Instead it rolls over old debt into new debt – and when it does so it takes on whatever the interest rate is when the debt is rolled over. And when this happens and interest rates have risen, the cost of servicing the overall debt goes up.

There may be trouble ahead

The federal government’s interest expense has only begun to reflect the higher interest rates. The average rate the U.S. paid in 2022 was just over 2%, which is up from the 1.61% average in 2021 but still lower than it’s been over much of the past decade. But even so, the effect is being felt. Since the Fed began hiking rates, the U.S. government’s exposure to debt interest has climbed sharply.

It may all sound a little worrying, especially amid talk of a recession – it is as if the interest on your credit card or mortgage suddenly jumped at a time when you were facing a possible cut in wages.

But there are some reassuring economic projections as well. Inflation declined substantially in the second half of 2022 and appears likely to be under control. And there is good reason to think that interest rates of 4% – or even less – are in the U.S.‘s future, as well as in the Federal Reserve projections. Whether there will be a “soft landing” in the economy – that is, a slowdown that avoids a recession – is not so obvious. While it is not inevitable, many indicators point to a recession in 2023.

Either way, the days of borrowing trillions of dollars at near-zero interest rates to finance extravagant spending are over for the foreseeable future.

Published at and elsewhere under a creative commons license.

Should the Federal Reserve Set its own Goals?

Gerald P. Dwyer

August 2022

The Fed is in a difficult situation, partly of its own making. Inflation, depending on how you measure it, is running on the order of 5 to 10 percent per year.

The Federal Reserve’s preferred measure of inflation – the personal consumption price index excluding food and energy prices – increased at a 4.8 percent annual rate for the first half of 2022. Other measures of inflation are higher. Goods and services produced in the economy have fallen. Real Gross Domestic Product (real GDP) fell at a 1.3 percent annual rate in the first half of 2022.

It was not all that long ago, from 2011 to 2019, when inflation averaged 1.5 percent per year.  The growth rate of real GDP over the same period was 2.2 percent per year. This is prior to the COVID-19 pandemic, lockdowns and extraordinarily large government stimulus payments.

Before the rapid recent increase in inflation, the Federal Reserve was attempting to increase inflation. The average of 1.5 percent per year from 2011 to 2019 is less than the Fed’s target of 2 percent over the same period. In an attempt to raise expected inflation, the Federal Reserve shifted from an inflation target of 2 percent to a flexible average inflation target of 2 percent. This was announced by Chairman Powell at the 2020 Jackson Hole conference. This average could easily be interpreted as reflecting an intention to have inflation above 2 percent for some time, given the average inflation of 1.5 percent from 2011 to 2019.

The large stimulus payments to the public financed by government debt purchased by the Federal Reserve generated outsized increases in the money supply, M2, which have predictably resulted in higher subsequent inflation. These developments increased the inflation rate, no doubt quite a bit more than the Federal Reserve intended.

Can we reduce the likelihood of similar errors in the future?

There were conceptual errors and there are no obvious structural changes that would help reduce these conceptual errors given the current discretion allowed to monetary policymakers. The Federal Reserve completely ignores the nominal quantity of money, M2, which was a serious mistake in this inflationary episode.

One way to reduce the likelihood of similar errors in the future is to make similar errors harder to make.

In this regard, a rule to constrain monetary policy could be helpful.

The Federal Reserve’s goal of average inflation of 2 percent per year can be interpreted as a rule of sorts. The Federal Reserve sets out a goal and the Federal Reserve attempts to hit it. This is a self-imposed constraint. An example from everyday life would be having a goal of saving 10 percent of every check for retirement. While some people are successful at doing this, many others find themselves buying shoes for their children with some of that 10 percent and being glad to be able to do it.

An alternative is an externally imposed constraint. Congress and the Administration could pass one of a variety of laws that would impose constraints on the Federal Reserve’s behavior.

One such rule is an inflation target. Rather than being announced by the Federal Reserve with the Federal Reserve able to change the target when it seems convenient, the target would be imposed by Congress and the administration.

The Federal Reserve might be tempted to increase its target inflation rate, in the belief that increasing the target will temporarily increase employment and decrease unemployment.

The increase in the target inflation rate is not hypothetical. It happened with the change to a flexible average inflation rate. In fact, some have been arguing for an increase to even 4 percent per year from some time.

The constraint I am suggesting is a constraint on the Federal Reserve’s goal.

Such a rule would not constrain the Federal Reserve’s interpretation of how to hit the target; it would constrain the target at which is it aiming.

Who would set the goal? There are alternatives with costs and benefits. A law passed by Congress and signed by the President could directly set the target or the target could be determined periodically by the President and his or her staff in discussions with the Federal Reserve.

An inflation target is not the only possible target. An inflation target ignores the growth of the economy and whether or not it is in a recession, summarized for example by real GDP. An alternative to inflation targeting is targeting nominal GDP, the dollar value of GDP, which combines the inflation rate with the growth of real GDP. Higher inflation is the goal if real GDP growth is lower.

For a target to be taken seriously, a range of inflation rates or nominal GDP growth rates is necessary. If the target is exactly 2.0 percent per year, the probability of hitting this target is zero. This means that deviations of inflation from the goal need not be taken seriously. Instead, with a range of 1 to 3 percent per year for example, inflation rates outside that range could be the subject of serious discussions. 

If the government imposes an inflation or nominal GDP target, what happens if the Federal Reserve misses the target? It is possible that the Federal Reserve misses the target on purpose, independent of the goal set by the President and Congress. That has not been an issue in inflation-targeting countries in which other branches of government have a role in setting the inflation target. There is no reason to think that the Federal Reserve would ignore the legislative and executive branches of government. As a recent summary of inflation targeting in the first country to adopt it indicates (Collins 2022, “Inflation Targeting in New Zealand”), New Zealand’s inflation targeting has had  temporary deviations from the target, not persistent ones.

A side benefit of having the executive branch and Congress participate in determining the target inflation rate would be the involvement of elected representatives of the voting public.

In sum, a target that is not determined solely by the Federal Reserve is less subject to changes solely due to deliberations at the Federal Reserve, which will enhance monetary policy’s effectiveness.

Government Debt and Inflation: Reality Intrudes

Gerald P. Dwyer

The last couple of years have witnessed extraordinary spending by the federal government. It has been quite the party. Figure 1 shows government spending since 2000. The increase to 30 percent of Gross Domestic Product (GDP) in 2020 stands out. Government revenue, also shown in Figure 1, does not jump. Federal government revenue in 2020 and 2021 are not particularly higher or lower than earlier years. The increase in spending was financed by dramatic increases in debt. Public debt issued by the federal government increased from 107.4 percent of GDP at the end of fiscal year 2019 to 127.6 percent of GDP two years later. As Figure 2 shows, the increase and the level are quite extraordinary.

Quite the extraordinary increase in 2020 and 2021.

Interest rates have been relatively low recently, which makes this level of debt not as onerous as it could be. In fiscal year 2021, the average interest rate on public debt was 1.8 percent per year. The low level of interest rates in the economy has made it possible for the federal government to borrow at historically quite low rates and to have relatively modest interest payments.

Federal government public debt has more than doubled since 2010.

There is every reason to expect these low rates to disappear in the next year or two. In 1981, after the Great Inflation, the federal government paid an average interest rate over 13 percent in 1981 and 1982.

Inflation in the United States today is running over 7 percent per year; the low level of current rates will not persist. Whether or not the level of rates gets to 13 percent depends in part on the Federal Reserve. The Federal Reserve plans on increasing short-term interest rates at its meeting on March 15. The only issue is whether the increase will be 25 or 50 basis points from the current Federal Funds rate range of 0 to 25 basis points. (25 basis points equals ¼ of a percentage point.) Given the level of inflation of over 7 percent per year, there is little doubt that the Fed’s target interest rate and the interest rates paid by the Treasury will be rising quite a bit over the next year or even two if inflation is to be subdued.

The implications of higher interest rates for the federal government’s budget are not appealing. Even at the low average interest rate 0f 1.8 percent per year, interest payments were 12.7 percent of federal government revenue in fiscal year2021.

What will happen when average interest rates on public debt increase? Holders of public debt today at 1.8 percent are losing on average more than 5 percent of the purchasing power of their funds in a year. An average interest rate of 5 percent on public debt suggests interest payments equal to 35 percent of current federal government revenue. This interest rate is hardly an attractive proposition though. At an interest rate of 5 percentage points, anyone holding public debt at current inflation rates still would be losing 2 percent a year in purchasing power. An average interest rate of 7 percent, high relative to recent interest rates but not high relative to recent inflation rates, would require 50 percent of the government’s revenue.

The Federal Reserve currently is committed to a slow increase in interest rates. A slow pace carries its own risks for controlling inflation. It does imply, though, that these extraordinary levels of interest payments compared to federal government revenue will not be reached in the near term. Just later rather than sooner.

There is a dilemma here though. Raising interest rates slowly given the current high inflation will let inflation get worse. Raising interest rates quickly has the potential to make the federal government’s budget deficit dramatically worse quickly.

Sooner or later, absent substantially lowering government spending or raising taxes, interest payments will overwhelm the government’s budget. The situation might even be termed a sovereign debt crisis because all the spending, revenue, deficit and inflation choices are unpalatable.

One plausible resolution of the dilemma is to increase inflation even more than people expect. This would inflate away the extraordinary debt issued in the last couple of years. In a way, it resolves the dilemma, just not in a very desirable way from the viewpoint of holders of depreciating US dollars.

Greedy Corporations and Inflation

Inflation in the United States in 2021 was over 7 percent. This is dramatically higher than just a couple of years ago when it was less than 2 percent per year.

Why did it go up? The most obvious answer – and the one consistent with an extraordinarily large amount of evidence – is the dramatic increase in the quantity of money in the economy. Effectively, this increase is similar to Milton Friedman’s hypothetical helicopter drop, in which money rains down from the skies, people pick it up and they spend it over time. The federal government’s stimulus payments, financed by increased government debt purchased by the Fed, were deposited directly into people’s accounts, eliminating the effort of picking up the money.

Not surprisingly, this extraordinary policy has been followed by a observed substantial increase in inflation. Given the size of the stimulus payments and the delay in spending the newfound money, there is no reason to expect inflation to slow down in the immediate future.

The Biden administration is taking credit for the stimulus payments but not for inflation.

Instead, they blame greedy corporations for raising prices. These price increases are supposed to reflect monopoly power that the corporations have. The problem with this story is that corporations with monopolies would have raised their prices already. Why wait? Firms raise their prices once and for all when they have less competition. They will not raise their prices gradually over months or years. Antitrust actions against supposedly greedy corporations will not reduce inflation.

The discussion of meat prices by the administration, especially beef, and meat packers is particularly egregious. Meat packers were “essential workers” during the lockdown. They work close together in enclosed spaces. Many of them got coronavirus during the lockdowns, slaughterhouses were closed, and some people died.

It seems more than a little plausible that fewer people would want to work in meat packing than before COVID. The all but inevitable result of this decrease in the supply of labor is an increase in wages. What has happened to the starting wage in slaughterhouses? It has increased from $14 to $22.50, an increase that is reflected in higher prices paid by consumers and a smaller quantity of beef slaughtered. The prices received by ranchers for beef can be expected to decrease: people are consuming less beef and the cows were in the pipeline. Under these circumstances, it’s hardly surprising that meat packers have a temporarily higher margin on the beef they are processing.

Focusing on the extraneous and completely ignoring monetary and fiscal policy was foreshadowed by a document published on the White House’s website last July. “Historical Parallels to Today’s Inflationary Episode” creates a clear impression that monetary and fiscal policy have little if anything to do with inflation. The three inflationary episodes in the last 50 years – since 1973 – are due to increases in oil prices. The earlier episode from 1969 to 1971 was due to a “booming economy” but was brought under control by price controls. The other two episodes after the Korean War and World War II are due to the elimination of price controls, supply “shortages” and “pent-up demand”. One looks in vain for terms such as money or monetary policy, even though Milton Friedman and Anna J. Schwartz’s work is mentioned in passing. The closest mention of monetary and fiscal policy is a passing reference to Federal Reserve Chairman Paul Volcker raising interest rates to lower inflation in the early 1980s.

Only a monetary policy geared to reduce inflation will be effective in reducing inflation. This is as true now as when the Federal Reserve lowered inflation in the early 1980s.

Wildcat Stablecoins?

Are stablecoins similar to notes issued by wildcat banks in the United States? Among some pushing for explicit regulation of stablecoins, apparently the answer is yes, including a U.S. Senator and Federal Reserve governors in talks and Gary Gorton and Jeffery Y. Zhang in a paper titled “Taming Wildcat Stablecoins.”

Stablecoins are cryptocurrencies that are designed to maintain a stable value relative to a fiat currency, gold or possibly other assets. The most traded have a redemption value of one U.S. dollar or one Euro.

Wildcat banking refers to some banks in the United States’ antebellum banking history. The name “wildcat banks” referred to banks that were started “where the wildcats roamed” in Michigan, which started a free banking system in 1837, the year it became a state. It is hard to think of Michigan that way today, but it was a frontier state at that time. Michigan was the first state to adopt free banking. It was a disaster.

This banking system was called “free banking” in the United States because entry did not require a discretionary charter from the state legislature with bribes required at times. Instead, someone wishing to start a bank only had to satisfy explicit legal requirements laid out in legislation.

There are fabulous stories of fraudulent activities in Michigan, stories that appear frequently in histories of free banking and general histories of banking. For example, in an examination report for Jackson County Bank in Michigan in 1938, the state bank commissioners report that they found the account books had accountholders’ names written in pencil and their balances written in pen. In addition, they examined the bank’s specie.

Beneath the counter of the bank, nine boxes were pointed out by the teller, as containing one thousand dollars each. The teller selected one of the boxes and opened it; this was examined and appeared to be a full box of American half dollars. One of the commissioners then selected a box, which he opened, and found the same to contain a superficies only of silver, while the remaining portion consisted of lead and ten penny nails. The commissioner then proceeded to open the remaining seven boxes; they presented the same contents precisely, with a single exception, in which the substratum was window glass broken into small pieces. (U.S. Congress 1839-40, 1109).

Whether or not these stories are typical of Michigan’s free banks, free banking in that state in the 1830s was a complete failure, with noteholders suffering heavy losses.

The title “wildcat banks” sometimes is applied to all banks in free banking states from 1837 to 1865.

Wildcat banking was not typical of banks in the free banking period from 1837 to 1865. In fact, the New York free banking system generated loss rates on outstanding notes less than 0.1 percent in any year after 1848. There was no Federal Reserve and no government insurance or bailouts.

There were indeed runs on some state banking systems. These were associated with developments that adversely affected the assets held by the banks. Because of state regulations, the assets backing the notes issued by the banks were state bonds owned by the banks and held at the offices of the states’ banking regulators. Federal government debt was not a suitable asset because there were only small amounts of federal government debt outstanding when free banking began. (Total federal government debt was $337,000 in 1837.) The requirement that banks hold state bonds was particularly problematic at the start of the Civil War, when banks in some states owned large amounts of Southern states’ bonds. These bonds fell substantially in value in New York and runs on banks in Illinois and Wisconsin ensued. Temporary suspensions of payments followed in Wisconsin and about half the banks closed. No such suspension was allowed in Illinois and almost all the banks closed.

The free banking episode ended in 1865 when the federal government taxed the free banks’ issuance of notes out of existence. The purpose of this law was to reduce the inflationary effects of national bank notes and bonds issued to finance the Civil War, not to replace an obviously bad banking system.

Not a pretty story in some respects.

What does it tell us about stablecoins? Pretty much nothing.

Issuance of notes by chartered banks and private firms is not confined to this period. Indeed, prominent proponents of what might be called “laissez-faire banking” such as Lawrence White and George Selgin argue that this period is a particularly poor choice for thinking about relatively unregulated issuance of private currency because banking regulations were quite restrictive and account for the problems in some states.

The experience in Michigan when it was a frontier state in the same year that the telegraph was invented is not particularly pertinent for discerning the likely success of private currency with the communications technology available today. “Wildcat” is a phrase that has no relevance for stablecoins.

The subsequent period, mentioned by Gorton and Zhang, is of some interest. The United States government required that banks hold U.S. government securities to back up their issuance of national banknotes. They did hold U.S. bonds and their holdings were verified on a regular basis. As Gorton and Zhang note, there were no runs on currency in this period before the creation of the Federal Reserve and deposit insurance.

Inflation and Coronavirus Monetary Policies

Is there any reason to think that inflation might increase in the near future after the current coronavirus lockdowns and stay-at-home orders end? The Federal Reserve is engaging in extraordinary policies that will substantially increase excess reserves in the banking system. That said, the Fed did similar things during and after the Financial Crisis of 2007-2008 and inflation has been benign since. Are the current policies as likely to have little or no effect on inflation?

There are contrasting views by experts, among them Tim Congdon in an op-ed in the Wall Street Journal and George Selgin on the Alt-M blog. Congdon says that “history suggests the U.S. will soon see an inflation boom.” Selgin says that “[I]f denying any risk of future inflation is unwise, so is exaggerating that risk, or claiming that it’s imminent when it isn’t.” Selgin quotes Olivier Blanchard as saying that the risk of inflation is “very small.”

In fact there is reason to be concerned that Federal Reserve policies will not work out so well this time.

The money stock increased substantially in March and April 2020One way of assessing future inflation is the quantity of money in the United States. Figure 1 shows that the money stock, M2, has increased substantially, even relative to the increase in the Financial Crisis of 2007-2009. Inflation, which loosely speaking results from “too much money chasing too few goods”, can result from more rapid growth of the money stock.

Lockdowns and stay-at-home orders and other disruptions associated with the coronavirus pandemic have reduced employment and output substantially. The size of the decreases remains to be seen but filings for unemployment insurance by roughly 30 million people in the United States certainly suggest a very large decrease in goods and services to be purchased by this larger stock of money. This decrease in goods and services available is likely to be temporary though, so it is the increase in the money stock that is a longer-term concern.

Is recent money growth likely to continue? To the extent that the increase in M2 is associated with stimulus payments and unemployment payments, that source of increases in M2 probably will not continue for more than a few months.

The Federal Reserve, though, is on track to increase its balance sheet and reserves in the banking system substantially by buying financial assets and making loans to private firms. Purchases of financial assets are little different than the Federal Reserve’s policy since the Financial Crisis of 2007-2008. What is there to worry about?

The Federal Reserve has been operating a system in which it pays banks to hold reserves over and above required reserves. The Federal Reserve has used those excess reserves, which are deposits at the Fed, to acquire assets, long-term Treasury securities and mortgage-backed securities. Figure 2 shows that excess reserves increased substantially during the Fed’s policy of quantitative easing (QE) implemented in QE1, QE2 and QE3 visible in the graph.

Current policy proposes to increase reserves and asset holdings substantially more in the near future. The size of that increase is not certain, but the Treasury has provided credit protection and equity investments of $235 billion in the financial vehicles acquiring assets and making loans. Excess reserves increased by 90 percent from March 25, 2020 to April 22, 2020. It would not be particularly surprising if excess reserves reached twice the prior peak of $2.7 trillion. They already exceeded that prior peak by over 10 percent on April 22 and surely will exceed it by 25 to 50 percent ultimately.

The outsize increase in the Fed’s balance sheet during and after the Financial Crisis of 2007-2008 quite obviously had little or no effect on the M2 or on inflation. Are there reasons to think that conditions now are different?

A major concern is that banks may not want to hold the additional reserves in excess of requirements. Why not? About a third of these excess reserves are held by U.S. branches of foreign banks. These reserves satisfy a recently added requirement for banks: the liquidity coverage ratio. Reserves at the European Central Bank (ECB) also satisfy this requirement but the Federal Reserve pays interest for holding reserves at the Fed while the ECB charges interest for holding reserves at the ECB. There is foreign-exchange risk associated with holding dollars instead of euros, but that apparently does not deter foreign banks from holding liquidity at the Fed instead of the ECB. Large U.S. banks also are subject to the liquidity coverage ratio.

Is the demand for excess reserves unlimited? There is a major constraint on banks’ desire to hold excess reserves paying a relatively low interest rate. That constraint is a required leverage ratio imposed by banking regulations. The leverage ratio is a minimum requirement of equity capital in a bank relative to assets. Expansion of assets by acquiring excess reserves eventually runs into the leverage ratio, at which point equity capital would have to be issued to satisfy the required leverage ratio and increase holdings of reserves. Given the cost of capital and the interest rate on excess reserves, any bank doing this would be reducing the value of the bank to shareholders. In short, banks will eventually stop adding excess reserves.

If a bank doesn’t want to hold an increase in its excess reserves, what can it do when its excess reserves increase? Instead of holding the excess reserves, the bank can loan the money out or buy a security after holding reserves equal to a fraction of its increase in customer deposits. Other banks would do the same. Through the traditional multiple expansion of deposits, the money stock would, unlike in recent years, increase because excess reserves are increasing. If the Fed does not reduce excess reserves, an increase in the money stock ensues.

Such an increase in the money stock due to Fed policy would increase the dollar value of goods and services produced. Printing money does not increase production of goods and services for very long if ever. Increases in prices and inflation ensue.

The recent and prospective increases in excess reserves are different because the creation of excess reserves did not run into the leverage ratio. Without running into the leverage ratio, monetary policy from 2010 to 2020 could let the demand for money determine the quantity of money. With low expected inflation, the growth of money was consistent with that low expected inflation and in fact low inflation followed. If the Fed increases excess reserves and holds fast to those increases, inflation can result if banks no longer find it advantageous to hold those excess reserves.

How big is this risk? It is fair to say that no one knows. As recently as Spring 2019, the Fed was reducing excess reserves and found that banks wanted to hold a much higher level of excess reserves than expected. Similarly, the upper limit to how much excess reserves banks want to hold is uncertain.

Not knowing the relationship between monetary policy and inflation is a risky way to conduct monetary policy. Maybe everything will work out fine; maybe not.

What Is Essential?

The recent government lockdowns and stay-at-home orders are long on lists of things that are essential and not essential without defining or saying what determines whether something is essential or not essential.

What does “essential” mean? A synonym in the Merriam-Webster dictionary is “necessary.” “Necessary” has the advantage of being less vague. It also raises a question: “Necessary for what?”

A good example of the arbitrariness of government officials determining what is essential is a recent dust-up concerning wrestling in Florida. Florida has determined that sporting events, including wrestling matches, are essential. The headline and subheading on a negative editorial show the split: “His explanation doesn’t make much sense” reads the headline with DeSantis’s explanation that “I think people have been starved for content … we’re watching, like, reruns [of sporting events] from the early 2000s” under it.

The headline was written by a true non-sports fan. To those of us who watch little if any sports on television, sporting events are not only not essential, they’re not even interesting.

On the other hand, for those who like to watch sports, the drought of sporting events has in fact resulted in people watching long-ago reruns of run-of-the-mill events because, for them, it’s better than nothing. They would be a lot happier with new sporting events.

Why pick on wrestling in particular? It is easy to make snide comments about wrestling matches, and wrestling matches have started. While the order concerns sporting events generally, wrestling matches do have an advantage that team sports such as baseball do not. There are few people in a locker room before a wrestling match. Before sports such as baseball and football can resume, they have to resolve a basic problem: How does one deal with many athletes preparing for a game? Even eliminating the physical audience or limiting the stadium to a fraction of normal capacity will not resolve that problem. Also, most sports are contact sports and definitely are not “socially distant” games. Wrestlers are in close contact with few people compared to the typical lineman in a football game.

Are wrestling matches or more generally sports events necessary? If you are a sports fan stuck at home worrying about when your life will resume, maybe so. It might be better than hitting the bottle.

Leaving aside sports, what is necessary? One person’s essential or necessary is another person’s unimportant.

To some people, going to church is essential to their salvation. To some people, going to a church is a waste of time.

Are “elective surgeries” essential? The shutdown of hospitals’ non-essential services, which includes bypass surgery, may already have increased deaths due to this apparently not-so-immediate ailment.

Is a lawn service necessary? If you don’t own a lawnmower because you employ a lawn service and can afford it, buying a lawnmower – if you can because lawnmowers are “essential” – is an expensive stopgap. Letting your lawn grow for a few weeks, a month or maybe longer might not be very attractive but might be the best thing to do. The worst part of declaring lawn services non-essential: Shutting them down in the name of “social distancing” reflects ignorance about how lawn services work. The workers mow the yard, do some trimming and leave. They are nowhere near the homeowner and not even close to each other besides in the truck.

Part of the argument for shutting down “non-essential” activities is that it is better to have fewer people going to work. This may have been a plausible argument while “flattening the curve.” It misses an important problem beyond that time frame.

It will take a year or more to create and produce a reliable vaccine in the quantity necessary for the United States. In the meantime, every activity accomplished with a stranger will involve the risk that the other person has coronavirus. Besides keeping most people in the U.S. at home until a vaccine is found for the coronavirus, the risk of contracting coronavirus while engaging in everyday activities will be a fact of life.

Taking care can limit the risk of contracting coronavirus. Wearing a mask might be a way to assure people that you are trying to avoid spreading coronavirus to them should you have it. Widespread and readily available testing can limit the risk because people will know whether or not they have coronavirus. Government edicts about “essential” and “not essential” activities are no help.

Coronavirus Lockdowns: When Will They End?

When will the lockdowns and business restrictions end? This is an extremely important question, the importance of which doesn’t seem to be widely appreciated or even acknowledged. Some others, notably The Wall Street Journal and John Cochrane are making related points about the importance of outlining when the lockdowns and business restrictions will end.

All the most recent developments are additional, severe closings of economic activity in much of the country. The governors of California, Illinois and New York issued decrees on March 20 similar to those in place in Italy and Spain and earlier in China. People are supposed to stay in their homes and not go out other than for “essential” reasons. On the same day, Pennsylvania ordered all “non-life-sustaining’ businesses to close and Florida ordered all restaurants closed for on-premises dining. This occurred after social distancing including widespread closures of businesses had been ongoing for over a week.

When asked about whether life might be close to normal by Easter, April 12, Dr. Fauci, head of the National Institute of Allergies and Infectious Diseases, responded “I can’t predict what the situation would be,” Fauci said. “I think we need to be prepared to modify behavior, even when it involves things that are very close to our hearts.” I do not want to over-interpret Dr. Fauci’s reply in an interview, but he certainly did not indicate that the end of these increasing restrictions is in sight. This is a profoundly disturbing state of affairs.

If the large-scale shuttering of businesses goes on for more than another week or so, many people’s lives will be ruined. While it is not entirely clear how many people in the United States live paycheck to paycheck, the number is far from zero. One estimate is that half of all people making less than $50,000 a year have no savings to pay the bills. Most people working in retail establishments and restaurants make less than $50,000 a year. These people have no way to buy food after not being paid for a short period. Some have credit cards, some don’t. Some have relatives who can help, some don’t.

There is no evidence that these grave consequences are being considered in a serious way. Instead, presentations tend to focus on technical issues and avoid the widespread suffering that soon will overwhelm many in the United States.

Discussions of the coronavirus need to change now and start focusing on when life can start to gradually return to normal.

The gradual lifting of these restrictions should be outlined soon. The lifting of restrictions should include measures taken by businesses and the government to limit exposure. The lifting also should take account of the costs of these restrictions on people. A gradual return of activity will occur naturally, no matter what. There is no evidence that people are ready to rush out to stores and restaurants right after restrictions are lifted. On the contrary, many restaurants decided to close to on-premises dining because few people were willing to venture out given concerns about the coronavirus.

In the meantime, the main preparation that will let people return to something like normal economic activity is testing. Testing anyone who thinks they might have coronavirus is the surest way to reduce infections and let people return to work with some confidence in their own health and others’ health.

Monetary Economists as Policymakers at the Federal Reserve

Several articles in recent years have claimed that more diversity in the sense of fewer economists on the Board of Governors and the Federal Open Market Committee (FOMC) would be a good thing (Fox “How Economics PhDs took over the federal reserve”; Zumbrum “Fed draws on academia, Goldman for recent appointees”; Calabria “Yes Fed has a diversity problem”; Ricketts “The Fed could use less book learning and more street smarts”). This is of some importance. There currently are three vacancies out of seven positions on the Board. One will be filled by the Vice Chairman for Bank Supervision. Several of the twelve bank presidents have turned over in the last few years and more may well turn over in the next few years.

This clamor seems to having an effect or at least reflects an opinion held by Reserve Banks’ boards of directors. The number of Ph.D. economists heading Federal Reserve Banks has fallen in recent years. Three presidents who were professional monetary economists and took strong stands have left, Naryana Kocherlakota, Charles Plosser and Jeffrey Lacker. The first two have been replaced by non-economists and the latter may well be also.

Positions at the Board are different than Reserve Bank presidents. Some positions at the Board are allocated to community bankers or bank supervision (Calabria 2016). The number of professional monetary economists who are community bankers is small and there is no reason to think that such a community banker would know more about monetary policy than other community bankers. The most important qualifications of the Vice Chairman for Bank Supervision concern knowledge about regulation (Davidson and Tracy 2017). There are qualifications for Board members based on geographic distribution that should be taken seriously (Calabria 2016).

These assorted criteria do not apply to Reserve Bank presidents. Furthermore, the operational work at Reserve Banks of clearing checks has disappeared and Reserve Bank’s most important roles concern monetary policy and supervision and regulation. Supervision and regulation at Reserve Banks is a Board function delegated by the Board to Reserve Banks. In the end, the Board is in charge of supervision and regulation.

If there is a reason to have Reserve Banks, monetary policy is it. Reserve Bank presidents have their own economics staff to brief them, a luxury that members of the Board of Governors do not have. Some of the Reserve Bank presidents who are economists have been quite effective at raising issues about monetary policy such as the desirability of the Federal Reserve’s holdings of mortage-backed securities.

Nonetheless, some think monetary policy would be better if fewer Presidents of Reserve Banks were economists. Would it?

There are two aspects of being a policymaker at the FOMC. Monetary economists have some expertise at one and substantial expertise concerning the other.

The FOMC sets the specific goals of monetary policy. The general goals are set by law but the specific goals in terms of inflation and real economic activity are determined by the FOMC. (I think it would be better if specific goals were set by Congress and the Administration but they are not.) Monetary economists have some expertise at determining the goals because they have thought about them more than most people, but staff assisting presidents provide this knowledge to some extent.

The FOMC’s other task is to use monetary policy tools to produce the goals. Whether or not members of the FOMC are economists, economists brief presidents of Federal Reserve Banks before FOMC meetings and monetary economists have particular expertise concerning these issues.

It takes serious economic analysis to understand how monetary policy worked even before the financial crisis. That is more true today.

There is not a consensus among monetary economists about how monetary policy works in the context of current policies such as interest on excess reserves and Quantitative Easing. (Or for that matter, even what the effects of Quantitative Easing are.) A Principles of Economics course is not sufficient to have the economics background to reach an informed judgement about how monetary policy works today and why alternatives are in error. An undergraduate economics degree twenty or thirty years ago is of no more use.

While it is possible for an economic advisor to teach a non-economist enough to understand the issues, it is difficult to imagine a policymaker ignoring the judgement of the economists who brief him or her. Some non-economists have been involved enough in monetary policy issues to have strong opinions before they are appointed. (Quarles is an example of someone who is being considered and has at least one strong opinion about monetary policy (Davidson and Tracy 2017).) Many if not almost all have not.

Economic advisors provide informed analyses and the FOMC meetings are informed discussion of the economy and monetary economics. Some policymakers are comfortable with briefings that reflect different opinions. Some are not. The judgements of the economists providing the briefing will play an important role in the choices made by a president, whether there is one point of view or more than one.

The economists briefing the President will play a far larger role if a President is not a monetary economist. The policymaker’s policy preferences might be different than the staff’s preferences on occasion but even these differences are unlikely to be important.

The argument is to appoint more presidents at Federal Reserve Banks who have no expertise in monetary economics and will be on the FOMC. Such appointments are unlikely to increase the level of discourse or the soundness of decisions at the FOMC. If such appointments have any effect, they most likely will enhance the importance of views held by the Reserve Banks’ economics staffs.


Calabria, Mark. 2016. “Yes, the Fed Has a Diversity Problem.” Cato at Liberty. June 23, at

Davidson, Kate, and Ryan Tracy. 2017. “Expected Fed Pick on Collision Course with Current Members on Rates.” Wall Street Journal, April 17, at

Fox, Justin. 2014. “How Economics Ph.D.s Took Over the Federal Reserve.” Harvard Business Review, February 3, at

Ricketts, Joe. 2017. “The Fed Could Use Less Book Learning and More Street Smarts.” Wall Street Journal. April 10, at

Zumbrun, Josh. 2015. “Fed Draws on Academia, Goldman for Recent Appointees.” Wall Street Journal, November 10, at