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The following is the text of a handy little card distributed to all new LBO subscribers. It was written in May 1994 by Doug Henwood, editor and publisher. It retains its copyright and may not be reprinted or redistributed in any form - print, electronic, facsimile, anything - without the permission of LBO.

The language of money

Financial markets exercise considerable influence over the economy, and central banks (like the Federal Reserve) exercise considerable influence on the markets, who are constantly trying to divine the central bank's intentions.

Central banks in general

CBs have two contradictory functions: minimizing inflation (requiring stringency) and preventing recessions from turning into depressions (requiring indulgence). They operate by changing the level of interest rates and the supply of money and credit.

Theorists differ on just how powerful CBs are. Strict monetarists picture CBs as directing nearly everything economic through their monetary control panels. Mainstream "eclecticists" allow for other influences - fiscal policy, technology, the international environment - but tend to agree that a CB is still in pretty firm control of the money supply. A small band of post-Keynesians argues, persuasively, that private credit demand really runs the show, since in all but abnormal times a CB simply accommodates private demand - itself determined by the current state of the real and speculative economies and players' feelings about the future.

A CB, as banker to the banks, accommodates (or frustrates) private credit demand by providing (or not providing) the banks with reserves, and by setting the level of short-term interest rates. (Reserves are that portion of deposits that banks keep in their vaults or on deposit with the CB; they're meant to provide a cushion in case of a run.) It's a matter of theological dispute which of these two policy tools - bank reserves and interest rates - is pre-eminent; LBO's position is that both matter.

How the Fed works

Policy is decided in secret by the Federal Open Market Committee (FOMC), which consists of the Fed's seven-member, Washington-based board of governors (named by the President and approved by the Senate) and five presidents of the Fed's twelve regional branches (who are chosen by each region's banks; they serve in rotation, except for New York's president, who is a permanent member of the panel). At these meetings, the FOMC decides on a target level for short-term interest rates and a desired rate of money supply growth. These decisions are published in highly sanitized form six weeks after their making. In the interim, overpaid Wall Street analysts try to decode the Fed's policy moves. Starting in February 1994, the Fed began announcing FOMC policy decisions immediately after they were made; it's not clear whether this is a permanent change.

The FOMC's policy targets are transmitted to the trading desk at the Fed's New York branch, which translates broad strategy into daily reality by either buying or selling appropriate amounts of government bonds, thereby providing or denying reserves to the banking system. Such moves are typically made at 11:45 AM, known as "Fed time" on Wall Street.

The degree of reserve pressure on the banks - whether they are flush with or short of spare cash - exerts a strong influence over their propensity to lend. So when the Fed wants a zippier economy, it provides reserves to the banks, who can lend their windfall to customers in the real world. Borrowers then use this new money to buy equipment or hire workers, thereby stimulating economic life. Conversely, when the Fed wants to tighten, it withholds or even drains reserves, thereby frustrating prospective borrowers and stifling economic life.

Reserve pressure also influences interest rates. When a bank makes a loan, it usually credits the borrower's checking account - but it has to have reserves available to cover the new deposit. If it doesn't, it must borrow the funds from depositors (remember - when you deposit money in a bank, you're lending it the money), other banks, or, as a last resort, from the Fed. The rate at which banks lend each other such short-term funds is called the Federal funds rate. It is the most sensitive indicator of Fed policy, since it is constantly set and reset with every change in the supply of and demand for bank reserves.

The Fed's most visible policy tool is its discount rate , the rate the Fed charges for loans to banks. Except for troubled banks, the Fed discourages borrowings from its discount window, so the discount rate has little practical significance. In fact, changes in the discount rate usually follow changes in the Fed funds rate, unless the Fed is trying to make a dramatic gesture. The ratio of the Fed funds rate to the discount rate measures the Fed's covert intentions: if it is low, the Fed is tending towards ease; if high, they're tightening. The average ratio for the past 40 years is 1.06; a high ratio begins around 1.24, a low one, at 0.88.

Money, interest rates, and the economy

Regardless of one's theoretical perspective, it's undeniable that changes in the money supply usually lead changes in the real economy by several months. (For such forecasting purposes, it matters little whether it's the Fed or the economy that's driving the money supply.) In general, slow money growth usually portends a slower economy and lower inflation; rapid growth, a faster economy, and higher prices.

Similar things can be said about the level of interest rates: lower rates stimulate the real economy, while higher rates dampen it. Consumers are more likely to buy expensive items like cars and houses when interest rates are falling, and less likely when they're rising. Businesses are more likely to invest and hire new workers when rates are falling then when they're rising: for cash-short businesses, falling rates make borrowing cheaper, while for cash-rich businesses, investment in real assets becomes more attractive than investment in paper ones.

LBO's money page graphs the Fed funds rate, its ratio to the discount rate, and two measures of the money supply. M1 is the narrowest measure of the money supply, consisting of currency and checking accounts. M2 adds savings accounts, non-institutional money market funds and short-term bank deposits to M1. M3, not shown on LBO's money graph, adds institutional money market funds and time deposits to M2. Normally the Ms move together, more or less. The Fed says it pays most attention to M2 - and M2 does seem to correlate best with the real world - but you can never trust what the Fed says.

© Copyright 1996, Left Business Observer. All rights reserved.

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