Cato Journal: Inflation Targets, Behavioral Economics, and Interest on Reserves

Federal Reserve, Cato Journal, The Fed, behavioral economics, inflation targeting, zero lower bound, balance sheet, normalization
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Silhouette archery shoots a bow at the target.The fall 2016 issue of the Cato Journal is now available. Along with articles on free speech, climate change, and the peculiar business of politics, the latest edition offers a full line up on pressing issues in the current discourse on monetary policy. Among them are pieces critiquing calls to raise the Fed's inflation target, the Fed's interest on reserves policy, and the Fed's decision-making capacity.

Don’t Raise the Inflation Target

William T. Gavin, a former vice president and economist at the St. Louis Fed, argues against proposals to raise the inflation target. Proponents of such a plan say that raising the target would give the Federal Reserve more room to cut interest rates the next time we run into a financial crisis or recession. But Gavin suggests this idea is based on faulty logic.

For one thing, Gavin writes, the Fed would have hit the zero lower bound in 2008 whatever the inflation target was at the time. Reaching zero has not been a conscious choice, but rather an inevitable result of emergency lending programs that flooded the market with bank reserves. And the Fed is likely to keep hitting zero, says Gavin, not because the inflation target is too low, but rather because monetary policymakers are too aggressive in cutting rates, and too cautious in raising them — this means rates have a downward bias over time.

What’s more, Gavin argues that low interest rates don’t necessarily boost the economy, due to their effect on work, saving, and investment. At the same time, low interest rates can encourage the kind of risk-taking that was behind the 2008 financial crisis in the first place.

Finally, Gavin believes that raising the inflation target would undermine its usefulness as a nominal anchor of market expectations. Higher inflation is costly too, both because of its deleterious impact on economic calculation, and because its interaction with the tax code has a growth-sapping effect on investment.

The Cognitive Biases of Central Bankers

Elsewhere, Cato’s Mark Calabria notes that 95% of the behavioral economics literature overlooks the cognitive biases of policymakers. He seeks to redress that balance with a preliminary analysis of the potential cognitive failures in Federal Reserve policymaking. These include availability bias, whereby certain historical episodes (like the Great Depression) dominate discussions of policy, even when the present situation is quite different; representativeness bias, according to which policymakers are inclined to make sweeping assumptions based on limited data; and status quo bias, which can make policymakers too slow to respond to changed circumstances. Calabria also points to loss aversion and overconfidence among central bankers.

There are ways to overcome cognitive biases, Calabria points out. However, the two methods the Fed would likely claim to be employing — expertise and committee-based decisionmaking — both have limitations. Expertise only helps when you operate in a regular, predictable environment, and have the opportunity to learn via repeated practice — neither of those conditions is met in the case of the Fed. Decision-making by committee, meanwhile, only helps to overcome cognitive biases when there is sufficient diversity of ideas among the committee members. It is hard to argue the FOMC meets that particular criteria.

This leaves two alternative ways to address monetary policymakers’ cognitive biases: following a rule, and subjecting decisions to adversarial review. I’ll leave readers to guess where Mark stands on those issues!

Phasing Out Interest on Reserves

Finally, leading monetary economist John Taylor reviews the massive expansion over the last decade of the Federal Reserve’s balance sheet. Quantitative easing, he points out, made the Fed’s paying interest on reserves inevitable — without it, the Fed would have no way to influence the federal funds rate, which it uses to implement its policy decisions. In the short term, Taylor writes, the Fed has no choice but to use interest on reserves as it seeks to normalize monetary policy by raising interest rates.

In the longer term, however, Taylor believes that the size and composition of the Fed’s balance sheet should be consistent with the federal funds rate being market-determined, rather than administratively determined by the Fed through interest on reserves. This means the Fed must reduce its securities holdings over time. To do otherwise would leave the Fed with too much power over credit allocation, as well as a quasi-fiscal role better left to Congress. The Fed, Taylor concludes, should get back to being a limited purpose monetary institution, setting its policy rate in a rule-like fashion.

You can find the latest issue of the Cato Journal, as well as archives stretching back to 1981, at

  • Spencer Hall

    Negative interest rates, remunerating IBDDs, and a "cashless" society are interconnected – and they are all contractionary. Keynes was wrong:

    In almost every instance in which Keynes wrote the term bank in the General Theory, it is necessary to substitute the term non-bank in order to make his statement correct. This is the source of the pervasive error that characterizes the Keynesian economics, the Gurley-Shaw thesis, the elimination of Reg. Q ceilings, the DIDMCA of March 31st, 1980, the Garn-St. Germain Depository Institutions Act of 1982, the Financial Services Regulatory Relief Act of 2006, the Emergency Economic Stabilization Act of 2008, sec. 128. “acceleration of the effective date for payment of interest on reserves”, etc.

    The CBs can force a contraction in the size of the non-banks/shadow banks, & create liquidity problems in the process, by outbidding the non-banks for the public’s savings. This acts to bottle-up savings and decrease money velocity. Un-spent or un-used savings are an un-recognized leakage in National Income Accounting procedures and theory.

    It's virtually impossible for the CBs to engage in almost any type of activity without altering the money stock. Impounding savings by increasing the ratio of interest bearing to non-interest bearing accounts within the commercial banking system increases the leakage (output gap), in Keynesian National Income Accounting.

    Thus all new financing under this new economic rubric will impact the money stock and decrease non-inflationary real-investment, or R-gDp's growth (i.e., increase secular stagflation)

    The Federal Reserve Act of 1913 was to: "provide for the establishment of Federal reserve banks, to furnish an elastic currency"

    "the amount of currency in circulation is determined by how much cash people want to hold (the demand goes up around Christmas shopping time)" – Ben S. Bernanke Eschew the seasonally mal-adjusted data and watch the volume of currency withdrawn during the holidays.

    In our managed currency system the volume of currency held by the non-bank public is impersonally determined by the needs of trade (cash-drain factor). It is impossible for the public to add to the total money supply consequent to increasing its cash holdings. Any expansion of the non-bank public’s holdings of currency merely changes the composition (but not the total volume) of the money supply.

    If we went to a "cashless" society, the volume of un-used savings would increase and the economy would decelerate. The volume of currency in circulation is commonly indicative of higher economic activity (transactions velocity), in the “underground economy” or illegal activity in the “black market” (where record-keeping & taxes are deliberately avoided). It has been estimated c. 9% of N-gDp.

  • Spencer Hall

    Contrary to the coward, Bankrupt u Bernanke: "Unfortunately, beyond a quarter
    or two, the course of the economy is extremely hard to forecast", economic
    prognostications (extraordinary movements in flow), within a year’s period are
    infallible (for the past 100 + years).

    Inflation drops precipitously in December, and then accelerates throughout 2017 (causing stagflation).

    01/1/2016 ,,,,, 0.20
    02/1/2016 ,,,,, 0.16
    03/1/2016 ,,,,, 0.13
    04/1/2016 ,,,,, 0.15
    05/1/2016 ,,,,, 0.19
    06/1/2016 ,,,,, 0.15
    07/1/2016 ,,,,, 0.15
    08/1/2016 ,,,,, 0.20
    09/1/2016 ,,,,, 0.20
    10/1/2016 ,,,,, 0.19
    11/1/2016 ,,,,, 0.19 peak
    12/1/2016 ,,,,, 0.11 bottom
    01/1/2017 ,,,,, 0.14
    02/1/2017 ,,,,, 0.13
    03/1/2017 ,,,,, 0.12
    04/1/2107 ,,,,, 0.13
    05/1/2017 ,,,,, 0.16
    06/1/2017 ,,,,, 0.12
    07/1/2017 ,,,,, 0.09
    08/1/2017 ,,,,, 0.13
    09/1/2017 ,,,,, 0.14
    10/1/2017 ,,,,, 0.14
    11/1/2017 ,,,,, 0.12
    12/1/2017 ,,,,, 0.05

    This is the forward look. Inflation breaks down in December 2016 (Yale Professor Irving Fisher's distributed lag effect of money flows). Sell commodities and buy bonds at Nov. month-end. Oil might drop $10 a barrel.

    That is the bottom in the U.S. price-level (independent from changes in the dollar's exchange rate). Then it rises going into 2017. And the reason it rises is because this extrapolation is not an extrapolation. It is holding the Federal Reserve's past policy constant (assuming zero growth, which is not a valid assumption). I.e., it is a "base-line".

    Therefore, even if the Fed doesn't supply any new money to our economy, inflation will accelerate. I.e., the money stock has not declined on a year-to-year basis since the Great Depression.

  • Spencer Hall

    The transactions concept of money velocity, Vt, not income velocity, Vi (not as was deprecated on Nobel Laureate Milton Friedman’s car license plate), has its roots in Yale Professor Irving Fisher’s “equation of exchange” P*T = M*Vt, where:

    (1) M equals the volume of means-of-payment money;

    (2) Vt, the transactions rate of turnover of this money;

    (3) T, the volume of transactions units; and

    (4) P, the average price of all transactions units.

    Irving Fisher’s economic axiom is a statistically validated truism, e.g., plugging in the #’s: to sell 100 bushels of wheat, (T) at $4 a bushel (P) requires the exchange between counterparties of $400 (M) once, or $200 (Vt) twice, etc. As Nobel Laureate Ken Arrow opined: “All analysis is a model”.

    Some speculative scientific theories depend upon induction: analyzing a lot of experimental findings and tying them together to explain the empirical patterns. What science teaches is the correlation between empiricism and theory.

    In Professor Fisher’s 1920, 2nd edition, of: "The Purchasing Power of Money", digitized for FRASER, he instructed:

    “If the principles here advocated are correct, the purchasing power of money — or its reciprocal, the
    level of prices — depends exclusively on five definite factors: (1) the volume of money in circulation; (2) its velocity of circulation; (3) the volume of bank deposits subject to check; (4) its velocity; and (5) the volume of trade. Each of these five magnitudes is extremely definite, and their relation to the
    purchasing power of money is definitely expressed by an “equation of exchange.”

    "In my opinion, the branch of economics which treats of these five regulators of purchasing power ought to be recognized and ultimately will be recognized as an exact science, capable of precise formulation, demonstration, and statistical verification.”

    The transactions velocity, a statistical stepchild, is the rate of speed at which money is being spent, i.e., real money balances actually exchanging counterparties. E.g., a dollar bill which turns over 5 times can do the same “work” as one, five dollar bill that turns over only once.

    It is self-evident from Fisher’s equation that an increase in the volume, and/or velocity of money, will cause a rise in unit prices, if the volume of transactions increases less, and vice versa. Of course, this is just the “unified thread” of algebra, estranged from “General Field Theory” of macro-econometric modeling.

    The algebraic way of stating Fisher’s econometric “flow” is: The rate-of-change in the product of the unit prices, and quantities of goods and services exchanged, P*T is equal, for the same time period (as empirically demonstrated by Fisher’s “distributed lag” effect), to the rate-of-change in the product of the volume, and transactions velocity of money. Note: N-gDp serves as a surrogate for all economic transactions -albeit AD does not precisely equal N-gDp (e.g., transfer payments, i.e., Social Security, Medicare, unemployment insurance, welfare programs, and subsidies, interest payments on the Federal debt, etc., are excluded).

    The upshot is that the rate-of-change, roc, in the proxy for the Fisherian “price-level”, and specialized price indices, is determined, ex ante, by monetary flows (our means of payment money times its transactions velocity of circulation). Note: The price-indices are subject to the limitations of all analyses based upon broad statistical aggregates, where data points in a time series must be accurately compiled in a manner which conforms to rigid theoretical concepts.

    Restated, Fisher’s reconstruction of the quantity theory of money, and heuristic techniques, describes the oscillating crests and troughs of the value of money. The Professor’s quantitative analysis was intended to “prevent and mitigate fluctuations” responsible for “producing alternate crises and depressions of trade.”

    But Federal Reserve Chairman Janet Yellen doesn’t follow George Santayana’s aphorism: “Those who cannot remember the past are condemned to repeat it"; viz., what the greatest American economist, Professor Irving Fisher, previously taught at Ivy League, Yale University during 1898 – 1935.

    As Dr. Richard G. Anderson, former FRB-STL senior economist and V.P. disclosed [Thu 11/16/06 9:55 AM]: “Nobody at the Fed tracks reserves.” Heretofore unbeknownst, legal reserves are the BOG’s true policy instrument, based upon member bank’s maintenance / compliance. Anderson is the world’s leading guru on reserves (telling me “required reserves are driven by payments”). SA’s Nattering Naybob called them “elephant tracks!”

    Opportunists can front-run “tomorrows’ WSJ”. Irving Fisher’s price-index will fall precipitously between November and December, as contrary to legendary Joseph Granville preached, fundamentals precede Joe’s technicals. November 23rd should mark your entry point. Speculators should short
    commodities and buy bonds (and then reverse their positions c. December 21st).

  • Spencer Hall

    "without it, the Fed would have no way to influence the federal funds rate, which it uses to implement its policy decisions. In the short term, Taylor writes, the Fed has no choice but to use interest on reserves as it seeks to normalize monetary policy by raising interest rates."


    I previously thought Taylor was intelligent. No longer. Just another cog in the wheel. You can distinguish between who understands macro, vs. who doesn't, simply by their reaction to remunerating IBDDs. You literally have to be a moron to believe in remunerating excess reserves, even required reserves, as schizophrenic Milton Friedman advocated (who was dimensionally confused, conflating uniform reserve requirements with eliminating depositors rate caps).

  • Benjamin Cole

    It is dispiriting to see Cato join the "tighter money, everywhere and always, is best" crowd.

    Scott Sumner a few years back wrote a little for Cato, and spoke of nominal GDP targeting, which is a promising approach.

    Worth noting is that the Fed appears presently to be holding short-term interest rates artificially high, through its reverse repo program.

    Gavin's idea that a central bank, by holding short-term interest rates artificially low, thus promulgates even lower rates in the future is an odd one. Really? Easy money leads to lower interest rates?

    There is a neo-Fisherian school of thought along these lines. If true, then when a central bank holds short-term interest rates artificially low, it results in lower inflation and interest rates. If Gavin is a neo-Fisherian, is that a bad result? Is it a bad result in general? Why? I thought low inflation is usually a positive.

    The tight-money crowd seems to have lost its bearings in the wake of QE and global deflation.

    Central banks are not statist-inflationist institutions any longer. Indeed, given deflation in Europe and Japan, and perhaps shortly in the U.S. (the next recession), one might hazard that central banks are hostages to bondholders, and are driving down inflation into disinflation and then deflation. That is the track record of the last 30 years or so.

    • Spencer Hall

      In macro-economics, unless the upper income quintiles’ savings (which are also proportionately greater), are either invested or otherwise put back into circulation thru spending, then a contractionary spiral is established and indeed perpetuated. This phenomenon has been artificially diagnosed as secular stagnation (structurally deficient aggregate demand). It first shows up as a decline in durable goods, and then capital goods (delimiting long-run productivity).

      AD falls as money velocity falls. Money velocity falls when non-bank lending/investing (non-inflationary investment) shrinks relative to commercial bank credit (inflationary spending/investment). Money velocity also falls when there is an excess of savings over investment outlets. But the principle reason why money velocity has fallen c. 1981 is because savings have been increasingly impounded within the commercial banking system. And this flies in the face of pedestrian common sense.

      It is a fact that the commercial banks pay for their earning assets with new money, not pooled savings. And it is a fact that CBs do not loan out existing deposits, saved or otherwise. CBs always create new money when they lend/invest. So, and this is high level thinking, monetary savings, or commercial bank-held savings, are lost to both consumption and investment when so held. Bank-held savings are an unrecognized leakage in National Income Accounting procedures. This is the source of the pervasive error that characterizes the Keynesian economics, the Gurely-Shaw thesis.

      The way to achieve higher and firmer interest rates, and saver-holder’s rates, is to get the CBs out of the savings business. This action increases the CB’s, NB’s, and retiree’s rates of return, viz., their profits and profitability, ROI & ROA. It also increases R-gDp instead of inflation. And understanding this is to know that we are headed in the opposite direction of economic and personal income growth, viz., an economic depression.

  • Spencer Hall

    Mr. Cole:

    "Scott Sumner a few years back wrote a little for Cato, and spoke of nominal GDP targeting, which is a promising approach"


    ? Targeting N-gDp maximizes inflation and minimizes real-output. And that's stupid when you can target R-gDp.