"The Future of Monetary Policy. International Finance, November 1999.

ACCORDING to many Wall Street analysts, when the Fed shortly raises interest rates by the expected quarter or half of a percentage point, nothing much will change: the economy will carry on growing, profits will carry on increasing and the stockmarket will carry on surging regardless. As one such analyst put it this week, when investors expect annual stockmarket returns well into double figures, why should a barely perceptible rise in the price of money alter their behaviour?

It is a good question. So long as the stockmarket and the economy at large are driven by boundless confidence, small changes in the price of money may have little direct effect. Of course, if the Fed set out to terrify the marketsraising interest rates, say, by two full pointsit might burst the Wall Street bubble and bring the economy to a sickening halt. But even then the downturn would not be caused by dearer money itself so much as by the shock of bad unforeseen news.

On the face of it, this is odd. Apart from knowing in advance about its own decisions, the Fed knows little or nothing about the economy that is not public information. The Feds influence on the economy ought therefore to be confined to the direct effects of interest-rate changes, effects that are already small and seem likely to get smaller. Yet the Feds influence goes beyond this. Its indirect power to move the markets, and hence the economy, is greatdespite being, as it were, a confidence-trick.

Maybe the direct effects, albeit small, are enough to give the Fed a fulcrum against which to apply its indirect leverage. This raises an intriguing question. What happens if the direct effects of changes in the Feds interest rates are zero?

This is an imaginable state of affairs, as a recent paper* by Benjamin Friedman of Harvard University points out. Traditional models put bank deposits and/or bank lending at the centre of the financial system. The Fed exerts influence because it is the monopoly supplier of the reserves that back the supply of bank money. By reducing the supply of reserves, it can cause the supply of bank money to falland market interest rates to rise. So goes the theory.

But bank money already matters much less than it used to. For instance, consumers nowadays routinely pay for goods and services not with cash or cheques drawn on their bank accounts but with credit cards, including cards not issued by banks. Meanwhile, other innovations have attacked the demand for bank credit. Non-bank intermediariespension funds, insurers and mutual fundshave greatly increased their share of the American credit market. These institutions do not hold balances with the Fed; for them, its monopoly over reserves is already irrelevant.

Furthermore, the advantage that banks traditionally enjoyed over non-banks in judging borrowers creditworthiness has been eroded by information technology: products such as home mortgages have become automated and commoditised. Even when banks initiate loans, the resulting assets can be turned into a security and sold. More than half of all American home mortgages are now held by securities-market investors; smaller but fast-growing proportions of consumer credit, trade credit and ordinary commercial loans are also being securitised. Again, these loans create no demand for reserves at the central bank.

In judging the significance of all this, it is best not to get carried away. For instance, the development of non-bank money in the form of non-bank credit cards does not entirely displace the Fed. Not yet, anyway. Final settlement of credit-card balances is still carried out through banks: the demand for bank money (and hence reserves) has been reduced rather than eliminated. However, Mr Friedman argues that the trend can go further. The crucial question is whether sellers will one day be willing to accept balances with non-banks, rather than only with banks, in final settlement. This is at least conceivable, as advances in information processing and encryption further erode the banks special position.

If it happens, incidentally, this is what e-money will mean. There will be no need for new units of account with silly names: for reasons of convenience, e-money will be denominated in dollars (or yen or euros). What matters about e-money is that in principle it need not be bank money in any sense. To use an old-fashioned term, it could take the form of purely private monies, entirely unsupported by reserves at the Fed. If the process went all the way, and the lines between banks, non-bank financial institutions and other sorts of enterprise blurred into invisibility, the Fed would indeed be left with no direct way to move the economy. And perhaps its indirect influence would then disappear as well: the chairmans view on the cost of credit would have as much sway as his view on the Dow Jones Industrial Average.

Would this matter? Maybe less than you might suppose. The Fed would lose its power to use interest rates to soften the business cycle. But during the current expansion it has chosen by and large not to use this power: emphasising uncertainties about the new economy, the Fed has tended to follow market rates rather than lead them. (Mr Greenspan has no truck with the old maxim that a central bankers job is to take away the punch-bowl just as the party gets going.)

The Feds ability to act as a lender of last resort would be missed, but the government could take on that job. And if banks fade away, that might be to the good. Banks are inherently fragile and systemically hazardous. Finance based less on deposits and more on securities might be less accident-prone. What about the risk of ever-expanding credit and persistently high inflation? Dont worry too much. These were unknown before the 20th centurythat is, before powerful central banks were invented.

*The Future of Monetary Policy. International Finance, November 1999.

-- thomas saul (thomas.saul@yale.edu), February 02, 2000

Answers

I think you just saved Bubble.com - it really could be in anew era and climb upward forwever.

Then again maybe not. THe DJIA closed down after trying to rally all day. Interest rates do affect the cost of money and the return on investmnet decisions of competing alternatives.

As the distintion between banks and non-banks blurs - look for real assets like gold and silver to appreciate because the blurring of distinction makes it difficult to properly value a "dollar".

-- Bill P (porterwn@one.net), February 02, 2000.

Thomas,

I think you mean "fiat". What is the tuition at Yale these days?

-- (perfesser@state.edu), February 02, 2000.

Hey, they don't have spell checkers on this thing. What can I say...Your answer "way tooo much" 35 plus change

-- thomas saul (thomas.saul@yale.edu), February 02, 2000.

Dude. You're in an Ivy League school and you need a spell-checker for the word "fiat"? Must have really nailed the math part of the SATs, 'cause verbal had to have been a struggle. 8-}

Math or Physics major, maybe Bio, right? Please don't say History or Lit. My poor ol' heart couldn't take it...

-- DeeEmBee (macbeth1@pacbell.net), February 02, 2000.

The 'Fed' has no intention of surrendering any control or authority. The only 'non-bank' financial institutions will be those controlled by the 'Fed'.

-- Y2kObserver (Y2kObserver@nowhere.com), February 02, 2000.

--I had two fiats. One was stolen. The second one cost me a lot of "greenspans" to rebuild it completely. Guess that was an example of me "inflating" bayless racing's "bottom line". Man, I sure had a lot of "interest" in that little "Fiat". It was yellow color, almost "gold". Originally it had a "stock" motor, but I rebuilt it. I was careful to not use any "bond"o in the bodywork. I was real careful to park it where I could see it at night, as a "hedge" against getting that one stolen. It had neato toggle switches for all the "e"lectronic things on it, like the lights and heater fan. It was a "convertible", too. I'm lucky I'm "short" because you couldn't "put" the seat back too far. I was lucky, never "crashed" in it. When you dropped the hammer, it had a "meteoric rise" in engine rpms because it was carefully balanced. At the "close" of daylight, I'd turn on the lights. Really don't recall if I ever drove by any "dow" chemical plants, though. Once, I almost went into a ditch, good thing I didn't "plunge" in, as I would have had to call some sort of "protection team" service to come and "pullout" the car. Man, every boy needs a sporstcar sometime. Chicks dig em, too. Guess that concludes my "Report" about my "Business" with that "Fiat" right now, don't need to make it a "Nightly".

: >)

-- zoggerini (alottaclams@spent.fun.dates), February 02, 2000.