Re: drop in demand for US bonds

From: Ron Hardin (rhhardin_at_mindspring.com)
Date: 09/13/04 

Date: Mon, 13 Sep 2004 08:04:01 GMT

William F Hummel wrote:
> >The Fed doesn't know what the money supply is, but it knows whether it's too
> >big or too small. It decided at its monthly meetings whether to make it
> >bigger or smaller _relative to what the economy wants_. The measure of
> >whether it's above or below that is the interest rate. A higher interest
> >rate means that the economy wants more than the Fed is supplying, a lower
> >one means it wants less. So the Fed changes the interest rate target to
> >tighten or loosen at its monthly meeting, and the the daily trading is done
> >to hit that target.
>
> The short term interest rate is a control variable, not an indicator
> variable. The FOMC holds eight scheduled meetings a year to review
> its interest rate policy. It gave up any pretense of targeting the
> money supply in July 2000, but in fact it hadn't targeted the money
> supply since the early 1980s.
>
> The FOMC sets the interest rate target based primarily on its forecast
> of inflationary pressures 12 to 24 months ahead. It pays virtually no
> attention to the money supply figures, over which it has no control in
> any case.

That's what I said. Hitting that target is using it as a control variable.
It indicates, however, money supply above target or below, relative to what
the economy wants. That's how it manages to control what they want to control -
if the money supply is too big, they reduce it, and if it's too small, they
increase it. It's controlling the money supply. It does so for a reason though.
They do not know and do not want to know how big the money supply is, only
where it is relative to the demand for money and their target that day. In effect,
they recalibrate this indicator every month, because the economy responds differently
every month.

Their meetings are not based on overnight interest rates though, because they
have contaminated them by using them as a control variable. They're based instead
on leading indicators of inflation that are independent of overnight interest rates,
which is conceptually trivial to do; the economy meanwhile responds to the new
money supply with minimal constraint, the Fed not having redirected any spending
beyond saying what its cost is this month in terms of borrowing.

One beauty of using fed funds rates is that you can decouple the control from the
leading indicators, and as a result do not go blind when you intervene. 

-- 
Ron Hardin
rhhardin@mindspring.com
On the internet, nobody knows you're a jerk.

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