Wednesday, April 7, 2010

Monetary Policy Is Not Magic

. Wednesday, April 7, 2010

Felix Salmon says something that makes no sense:

Shahien talks to former Fed governor Laurence Meyer, who reads this as a protective move by the Fed: the regional Fed banks, in particular, would have a much harder time justifying their existence as large institutions if they lost their supervisory role. And Meyer is surely right. Yes, information from bank supervisors can be used in FOMC meetings — but the Fed could have people supervising any sector of the economy and then use that information in its meetings. The point of supervising banks is to supervise banks, not to set monetary policy.
(emphasis added)

What's wrong with this? It doesn't think about how monetary policy works, or the mechanisms by which the Fed influences the economy. So how does it work? When the central bank raises (lowers) interest rates on funds available to banks they are effectively reducing (increasing) the supply of funds into the banking sector; banks respond by demanding fewer (more) funds, which means they have fewer (more) funds to loan out to borrowers; a leftward shift in the supply curve raises (lowers) the price of funds, when means raising (lowering) the interest rates charged to borrowers and paid to depositors. If interest rates rise (fall), demand for funds will fall (rise), so the money supply increases (decreases) through interest rate management. If the money supply increases (decreases), then economic activity also increases (decreases).

But all of that depends on the banking sector. In order for interest rate management to influence the broader economy, the banking sector must be healthy enough to issue new loans when interest rates are low and survive when interest rates are raised. If the banking sector isn't healthy, then the central bank has no traction over the economy: it can pump cash into the banking sector during downturns, but if banks just hoard it then it won't help get the economy moving again. In fact, we've seen a lot of this occurring since 2008; monetary policy has actually been contractionary, since banks have just hoarded the cash the Fed is trying to move through the system:

Indeed, one of the most notable features of the present crisis has been the explosion of banks simply keeping their money on deposit at the Fed. During 2008, these deposits increased by a factor of more than 40: from $21 billion to $860 billion.

All to say, the central bank really does need to know what's going on in the banking sector in order to set monetary policy, for reasons that have nothing to do with regulation. (Although that's also related, and I may blog more on that point soon.)

Note that this is not the same thing as being in a liquidity trap; I didn't mention the "zero bound" at all above.


Monetary Policy Is Not Magic
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