Contractionary Monetary Policy...Oh boy

NOW???? Really....

I personally cannot think of a worse time to do this...but over at the economist, Ezra Klein posted this....

HERE

EZRA KLEIN notes that the Fed is plowing ahead with its planning for withdrawal of monetary supports for the economy, like:

"The Federal Reserve on Monday proposed allowing banks to set up the equivalent of certificates of deposit at the central bank, a move that would help the Fed mop up money pumped into the economy and prevent inflation from taking off later.

Under the proposal, the Fed would offer "term deposits" that would pay interest. Doing so would provide banks with another incentive to park their money at the Fed, rather than having it flow back into the economy.

The proposal comes as no surprise. Federal Reserve Chairman Ben S. Bernanke and other Fed officials have repeatedly said the creation of "term deposits" -- essentially the equivalent of CDs for banks -- would be one of several tools the Fed could use to drain money from the economy when the time is right."

"When the time is right" says the story, but the Fed's commitment to undo its interventions is already having an effect. In expectation of more of these moves to come (as well as, perhaps, increases in interest rates) markets have been bidding up the dollar, which has busily appreciated during the month of December. That, in turn, will deprive the American economy of a potential source of demand—growth in consumption of American exports thanks to the effect of a weak dollar.

More bluntly, we're seeing a move toward contractionary monetary policy at a time when unemployment is at 10%. Funny that.

And, over at this SITE:

HERE
I've been thinking about this question more and I've come up with a speculative possibility. Right now banks are earning their way back into profitability by playing the spread. They're paying close to zero on deposits and earning fair sums on long-term loans. Perhaps this term structure is sustainable because people are expecting little inflation in the short run but moderate inflation in the longer run, plus there is some risk on the loans. (These inflationary expectations may be changing; if you wish pretend I am writing this six months or a year ago.)

So let's say we move from zero expected short-term inflation to three percent short-term expected inflation. The nominal short rate rises to three percent and the real short rate remains more or less constant. Long rates would go up a bit but not much, since beyond the short run there is already an expectation of moderate inflation. In sum, the spread between short and long rates might narrow.

Here is the key point: from the bank's point of view, what is the correct measure of the real rate of interest? Is it defined by the nominal rate relative to the expected growth in the CPI? I doubt it. When you're near the bankruptcy or nationalization constraint, it's often nominal profits that matter (relative to fixed nominal liabilities, accounting standards, capital standards, etc.), not "real profits" defined relative to the CPI.

In sum, maybe three percent expected inflation conflicts with the desire to rapidly recapitalize banks through maintaining a wide interest rate spread. Maybe we need that zero nominal short rate or at least the Fed thinks we do.

I don't wish to push too hard on this hypothesis, it is speculative rather than confirmed by evidence. And propositions about the term structure of interest rates do not always run the way you think they will or should. I'm aware of other problems. What kind of zero profit condition is imposed on the banks? Given the odd objective function of the banks, how exactly does the Fisher effect work in the short run? Or is it imposed from without by competition from non-bank lenders? I'm not sure on these questions and they suggest possible holes in the above speculation.

I also regard this as a somewhat gruesome hypothesis. It means that "Main Street" is paying for "Wall Street" (forgive me the use of those awful terms) in at least two ways: high unemployment and inability to earn much on one's savings. Risk on the Fed balance sheet is also paying some big part of the bill, since presumably that is helping to maintain the interest rate spread.

The term structure also implies that the market is expecting rising short rates, so if the bank mess isn't cleaned up soon, heaven forbid. The spread, as a means of restoring bank profitability, won't last forever.


This combined with the possibility of hits to the export markets due to contractionary policy scares the living cr*p out of me. What a way to start 2010.

BTW- found the second link over at Angry Bear. Just want to make sure to give credit where due.