Thursday, April 05, 2007

Is the Fed really "pumping money"?

There's an interesting exchange on the issue of Fed induced liquidity over at Mish's blog.

Author Mish seems to think the idea that the Fed is able to pump money and liquidity into the system is a bit of a misconception. He decided to contact one of the writers at the Minyanville website and voice his objections to a statement about the "Fed pumping money" that appeared in the writer's article.

In Mish's view, "pumping money" is not exactly what is going on here. He makes his case clear to the writer in question, who decides that Mish has made an interesting argument that merits further study and added insight from his community members.

Here is a small excerpt from that debate, starting with Mish's point of view:

Here is how I look at things:

This Fed has chosen to defend an interest rate target. The Fed must supply all demand for credit at that target. If the Fed failed to do so the interest rate target would not be hit and interest rates would either rise or drop accordingly.

Now I am a big fan of abolishing the Fed and letting the market set rates, but as long as the Fed has an interest rate target (as opposed to a money supply target) the Fed is not pumping money per se, the Fed is defending an arbitrary target that it has established, no more no less. Thus it is not the Fed initiating anything, the Fed is merely meeting demand for money at the arbitrary target they set.

The last sentence of Mish's excerpted comments are key to my understanding of his position. In his view, with regards to money/liquidity creation, the Fed is not "initiating anything", they are simply "meeting demand for money at the arbitrary target they set".

Now here's the key rebuttal point that I got from one of the Minyanville members (quote from "Professor Succo"):

The Fed has set an artificially low interest rate. The market wants higher rates because it sees the problems these low rates are causing: that money is getting into speculation and very low grade credit. The Fed must supply enough new credit (repo) in order to keep rates from rising. The recent steepening of the yield curve is telling us that this is hard to do: they are doing too many repos trying to keep rates low.

If the Fed wants to stop pumping money they would admit that rates are too low and would raise them.

In fact the recent steepening is very alarming. It is due to defaults/foreclosures where lenders are saying they cannot continue to pass on to speculators/low quality borrowers all that new credit the fed is trying to force into the market.

In the Professor's view, the Fed is not "merely meeting demand" for money and credit; they are actively supplying it by force to the market.

Which view is correct? Beats me. I can say one thing, though. There is some interesting debate here, and this exchange will expose a few more people to some of the lesser-known mechanics of money creation and banking.