A tighter versus easy stance

By Dr Frank Shostak

After a prolonged period of easy monetary policy, the US central bank the Fed has embarked on a tighter monetary stance. On May 4 2022, the Fed raised its benchmark interest rate by 0.5% to a target range between 0.75% and 1%. The hike is the largest since 2000 and follows a 0.25% increase in March this year, the first increase since December 2018. 

Various commentators expect the Fed to raise rates several times in 2022, reaching 2.9% in early 2023. Starting in June this year Fed policy makers also plan to shrink the Fed’s $9 trillion asset portfolio. The key reason behind the tighter monetary stance is the large increase in the yearly growth rate of the consumer price index (CPI) which stood at 8.5% in March against 2.6% in March last year.

By a popular way of thinking, it is the role of the central bank to make sure that economy follows along the path of stable economic growth and price stability. On this way of thinking, the economy is perceived to be like a space ship, which occasionally slips from the trajectory of stable economic growth and stable prices.

Following this way of thinking when economic activity slows down and falls below the path of stable economic growth and stable prices, it should be the duty of the central bank to give it a push, which will place the economy back on the stable growth path. The push is done by means of loose monetary policy i.e. the lowering of interest rates and by raising the growth rate of money supply. Conversely, when economic activity is perceived to be “too strong”, then in order to prevent “overheating” it should be the duty of the central bank to “cool off” the economy by introducing a tighter monetary stance. 

This amounts to raising interest rates and slowing down monetary injections. It is believed that a tighter stance is going to place the economy on a trajectory of stable economic growth and stable prices. Note that in this sense, it would appear that a tighter monetary stance could counterbalance the effects of the previous loose monetary stance. 

Hence, following this way of thinking it makes a lot of sense for the central bank to watch the economy all the time and make the necessary adjustments in order to keep it on a stable growth path. 

Why tight monetary stance cannot erase the effects of an easy stance?

We suggest that a tight monetary stance cannot undo the negatives of the previous loose stance. The misallocation of resources due to a loose monetary policy cannot be reversed by a tighter stance. According to Percy L. Greaves, Jr. in “The Causes of the Economic Crisis and other essays before the Great Depression” – Mises Institute- Books/ Digital text

Mises also refers to the fact that deflation can never repair the damage of a priori inflation. In his seminar, he often likened such a process to an auto driver who had run over a person and then tried to remedy the situation by backing over the victim in reverse. Inflation so scrambles the changes in wealth and income that it becomes impossible to undo the effects. Then too, deflationary manipulations of the quantity of money are just as destructive of market processes, guided by unhampered market prices, wage rates and interest rates, as are such inflationary manipulations of the quantity of money.

A tighter monetary stance, whilst likely to undermine various bubble activities is also likely to generate various distortions thereby inflicting damage to wealth generators. 

Note that a tighter stance is still intervention by the central bank and in this sense; it does not result in the allocation of resources in line with consumers’ top priorities. Hence, it does not follow that a tighter stance can reverse the damage caused by inflationary policy. 

We are of the view that by freeing the economy from central bank interference with interest rates and money supply, the process of wealth destruction is going to be arrested. This we suggest is going to strengthen the process of real wealth generation. With a greater pool of wealth, it is going to be much easier to absorb various misallocated resources.  Note that some resources however due to their nature will be probably much harder to absorb. 

For instance, a demand for some capital goods and certain human skills could disappear or weaken significantly in the new free market environment. We suggest that a tighter stance is also going to undermine various activities that emerged on the back of the previous easy monetary stance. Hence, this is likely to hurt various bubble activities. The more bubbles generated during the period of an easy monetary stance the greater the bust is likely to be. 

We suggest that the Fed tampering with market signals undermines the process of wealth generation thereby exerting an upward pressure on the time preference interest rate and the market interest rate. A strengthening in the market interest rate is likely to steepen further once the Fed will start trimming its balance sheet. Over time, however the trimming of the balance sheet is going to benefit the wealth generation process, all other things being equal. As a result, this will work towards the lowering of the time preference interest rate and the market interest rates.

Can central bank policies keep the economy on stable growth path?

Most experts are of the view that a major obstacle for the attainment of stable growth and stable prices path are the fluctuations of the federal funds rate around the neutral interest rate. 

The neutral interest rate, it is held, is the one that is consistent with stable prices and a balanced economy. What is required then is for Fed policy makers to successfully target the federal funds rate towards the neutral interest rate, so it is held. (According to this view, the main source of economic instability is the variability in the gap between the money market interest rate and the neutral interest rate). 

Note that in this framework of thinking the neutral interest rate is established at the intersection of the aggregate supply and aggregate demand curves. If the market interest rate falls below the neutral interest rate, investment will exceed savings implying that aggregate demand will be greater than the aggregate supply. Assuming that the excess demand is financed by the expansion in bank loans this leads to the creation of new money, which in turn pushes the general level of prices up.

Conversely, if the market interest rate rises above the neutral interest rate, saving will exceed investment, aggregate supply will exceed aggregate demand, bank loans and the stock of money will contract, and prices will fall. 

Hence whenever the market interest rate is in line with the neutral interest rate, the economy is in a state of equilibrium and there are neither upward nor downward pressures on the price level. The main problem here is that the neutral interest rate cannot be observed. How can one tell whether the market interest rate is above or below the neutral interest rate? 

Despite the fact that the neutral interest rate cannot be observed economists are of the view that it could be estimated by various indirect means. In order to ascertain the unobservable neutral interest rate economists now employ sophisticated mathematical methods such as the Kalman filter.  However, does all of this make much sense?  

Note again that in the process of attempting to ascertain the stable growth path, economists assume the existence of aggregate supply and demand curves. The intersection of these curves generates the so-called equilibrium that supposedly corresponds to the growth path of economic stability.

Now, the supply and demand curves as presented by popular economics does not originate from the facts of reality but rather from the imaginary construction of economists. None of the figures that underpin the supply and demand curves originates from the real world – they are purely imaginary. According to Mises, 

“It is important to realize that we do not have any knowledge or experience concerning the shape of such curves.” 

Yet, economists heatedly debate the various properties of these unseen curves and their implications regarding government and central bank policies. 

Why general equilibrium is a fiction

We suggest that the existence of a general equilibrium as depicted by the intersection between the overall economy supply curve with the overall economy demand curve is questionable. The economy as such does not exist apart from individuals. Hence, something that does not exist cannot strive to some kind general equilibrium. The concept of equilibrium is only relevant to individuals.

Equilibrium in the context of an individuals’ conscious and purposeful behavior has nothing to do with the imaginary equilibrium as depicted by popular economics. Equilibrium is established when individuals’ ends are met. 

When a supplier is successful in selling his supply at a price that yields profit, he is said to have reached an equilibrium. Similarly, consumers who bought this supply have done so in order to meet their goals. Again, every individual in his own context achieves his equilibrium whenever he reaches his goal. 

Observe that in the absence of central bank interference the interest rate that will be established is going to be in line with individuals’ various goals. This interest rate will reflect individuals’ goals and not the wishes of central bank planners. 

Thus, some individuals might discover that the interest rate that they would have to pay is much lower than what they are ready to pay. For some other individuals, the free market interest rate may turn out to be far too high. 

Consequently, they are going to be out of the market. (We suggest that the marginal lender and the marginal borrower set the market interest rate. The intersection of the supply and the demand curves does not establish the market interest rate).

Now, once policies are implemented to achieve the neutral interest rate, which supposedly reflects the so-called general equilibrium as established by the mathematical models, this is likely to be in contradiction of what the free market would have established. 

As a result, this is going to generate the misallocation of resources and the weakening of the process of real wealth generation i.e. economic impoverishment. (Note that by setting the federal funds target rate, Federal Reserve policy makers are pretending that they have the numerical information of the interest rate that corresponds to the growth path of stable economic growth and stable prices). 

The failure of various centrally planned economies such as the former Soviet Union is a testimony that central authorities attempt to push the economy towards the growth trajectory as dictated by the government bureaucrats’ results in an economic disaster. 

We hold that rather than raising interest rates to counter strong increases in the prices of goods and services, the Fed should close all the loopholes for the generation of money out of “thin air”.

Conclusion

We hold that the view that the economy can be seen as a space ship is erroneous, since the economy is about acting human beings that interact with each other. Individuals are consciously engaged in the pursuance of their various goals by employing various means. 

Contrary to the popular way of thinking, the damage caused by inflationary policy cannot be neutralized by a deflationary policy. The deflationary policy is a policy of intervention and in this sense; it sets in motion a different form of the misallocation of resources.