Fed Operating Procedure – Don’t Let the Perfect Be the Enemy of the Good

The Federal Reserve currently is involved in one of its periodic navel-gazing exercises to try to improve its monetary-policy procedures. Most likely this introspection will involve issues such as identifying the level of the “neutral” federal funds interest rate, the lags between a change in the federal funds rate and the cumulative effect on the inflation rate and the unemployment rate, how to move the federal funds rate in periods of heightened uncertainty and how to more effectively communicate with the public on monetary-policy issues. But, it is doubtful that the Fed will contemplate abandoning the federal funds rate as its primary policy tool. In what follows, I am going to propose that a lot of the Fed’s monetary-policy conundrums could be solved by targeting a monetary quantity, rather than an interest rate. The monetary quantity I would propose the Fed target and hit is the sum of the monetary base (which is the sum of cash reserves of depository institutions plus currency in circulation) plus the loans and securities held by depository institutions (commercial banks, savings and loans and credit unions). I have called this monetary quantity thin-air credit because it is credit that is created, figuratively, out of thin-air. In what follows, I will present a theoretical argument for proposing thin-air credit as the Fed’s operating tool as well as empirical evidence for supporting thin-air credit. I will argue that targeting and hitting a steady rate of growth in thin-air credit in periods of exogenous shocks to the economy, such as pandemics, tariffs, etc., will prevent the Fed from making policy moves that will exacerbate the effects of these exogenous shocks on the economy. The proposal that the Fed target a monetary quantity rather than an interest rate was popularized by Professor Milton Friedman. The only difference between my proposal and Friedman’s is that the monetary quantity I prefer is thin-air credit rather than some money supply definition.

What does it mean that the sum of the monetary base and the loans and securities of depository institutions are created “out of thin air”? When the Fed purchases securities in the open market, from where do the funds come that the sellers of these securities to the Fed receive? They come from bookkeeping entries on the Fed’s balance sheet. On the asset side of the Fed’s balance sheet, “securities held” increase by the amount of securities purchased by the Fed in the open market. On the liabilities side of the Fed’s balance sheet, “deposits of depository institutions” increase by the same amount. These deposits of depository institutions are also referred to as reserves held by depository institutions at the Fed. These reserves were created by nothing other than Fed balance-sheet entries. On the balance sheet of the depository-institution system, the asset item “reserves held at the Fed” increase by the amount of the securities purchased by the Fed and the liabilities item “deposits” increase by the same amount. Again, nothing but bookkeeping entries. The sellers of the securities to the Fed now have deposits that they can use to purchase goods, services and/or assets. Moreover, the depository-institution system has additional funds that can be used to make additional loans and/or purchase additional securities. The recipients of these additional loans issued by depository institutions are able to purchase goods, services and/or assets. Because depository institutions desire to hold only a proportion of their assets as reserves, the depository-institution system is able to increase its holdings of loans and securities by some multiple in excess of the reserves created by the Fed. This enables the recipients of funds from increased depository institutions loans and securities to purchase goods, services and/or assets without any other entity needing to reduce its current purchases of goods, services and/or assets. It is as though the Federal Reserve and the depository-institution system are legal counterfeiters. They can create additional credit, not with a literal printing press, but by bookkeeping entries. The Fed and the depository-institution system are able to create credit, figuratively, out of thin air.

Now, let’s rewind the tape. Instead of the Fed purchasing securities in the open market, assume that the purchaser of securities was some entity other than the Fed or the depository institution system. From where did this entity get the funds to purchase the securities? This entity might reduce its current spending on goods, services and/or assets by the amount of its purchase of these securities. This is often referred to as an increase in saving. In this case, the seller of securities can purchase goods, services and/or assets. But the buyer of these securities is reducing its purchases of goods, services and/or other assets. In this case, the purchaser of securities is transferring purchasing power to the seller of securities. Under these circumstances no net increase in the purchases of goods, services and/or assets occurs. In contrast, the sale of securities to the Fed set in motion a series of bookkeeping entries that did result in a net increase in the purchases of goods, services and/or assets. To a borrower, it makes no difference whether the lender is the Fed or a depository institution. But to the borrowers’ effect on the aggregate economy, it makes all the difference in the world whether or not the lender was the Fed and/or the depository institution system.

The Fed’s so-called dual mandate is to promote low unemployment and low inflation. Real GDP growth is related to the unemployment rate. All else the same, if real economic growth is close to its potential, which is a function of available productive resources and the productivity of those resources, a low unemployment rate would likely result. In the past 70 years, the compound rate of growth in real GDP has been 3.03%. In the past 70 years, the compound rate of growth in the Congressional Budget Office’s estimate of real potential GDP has been 2.99%. So, let’s say that growth in real GDP of 3% would come close to generating an acceptably low unemployment rate. For reasons unknown to me, the conventional wisdom is that the consumer inflation rate ought to be around 2% annualized. In the past 70 years, the compound annualized rate of growth in both the GDP and Personal Consumption chain prices indices has been 3.2% on a rounded basis. What I am suggesting is that if the Fed could conduct policy such that the growth rate in nominal GDP were around 5% (3% real and 2% GDP price inflation), the Fed would come close to meeting its dual mandate of low unemployment and low inflation.

If only there were some monetary quantity whose behavior would be relatively highly correlated with the behavior of nominal GDP. Oh wait, there is. It is the sum of the monetary base plus depository institutions’ holdings of loans and securities, i.e., thin-air credit. Plotted in Chart 1 are the year-over-year percent changes in annual averages of nominal thin-air credit (blue bars) and nominal GDP (red line) starting in 1955 and ending in 2019. That “r = 0.65” in the upper left-hand corner of the chart is the correlation coefficient between the two series. If the two series were perfectly correlated, the absolute value of the correlation coefficient would be 1.0. Because there is an implicit “+” sign in front of the 0.65 correlation coefficient, it means that when thin-air credit growth increases, nominal GDP growth also increases and vice versa. An absolute value of 0.65 for a correlation coefficient is not bad for government work. Why did I truncate the series to 2019 rather than 2024? Because the correlation coefficient is higher for the truncated period. How’s that for honesty? My deceased friend and former colleague, Robert “Bob” Laurent, remarked that I was the most honest economist he had ever encountered. NOT the BEST, but the most honest. The correlation coefficient drops to 0.45 when the years 2020 through 2024 are included. This is because of the record growth and near-record growth in nominal thin-air credit in 2020 and 2021 and the unusual contraction in nominal GDP in 2020. All of this was due to the once-in-a-century (I hope) pandemic and the Fed’s errant response to it.

Let’s break down the relationship between growth in thin-air credit growth, real GDP and the GDP chain price index. Plotted in Chart 2 are the year-over-year percent changes in real thin-air credit (nominal thin-air credit deflated by the GDP chain price index), the blue bars, and real GDP, the red line. Lead-lag testing by me shows that the highest positive correlation between the two series, 0.58, from 1955 through 2019 occurs when the series are coincident. That is, a change in real thin-air credit in a given year is most related to a change in real GDP in the same direction in the same year. Given my limited knowledge of econometrics and accessible software to test, causality in this case is ambiguous. A change in real thin-air credit might cause a change in real GDP in the same direction or vice versa.

Now let’s examine the relationship between changes in nominal thin-air credit and changes in the GDP chain price index. Plotted in Chart 3 are the year-over-year percent changes in nominal thin-air credit (the blue bars) and the GDP chain price index (the red line). Note that the percent changes in thin-air credit have been advanced by two years. In terms of the chart, the change in thin-air credit Year X is associated with the GDP inflation rate in Year X+2. For example, the change in thin-air credit in 2020 was most associated with the GDP inflation rate in 2022. The time period for this analysis has been extended because it yields a higher correlation coefficient and it demonstrates that the surge in thin-air credit in 2020, engineered by the Fed, was associated with the surge in GDP inflation in 2022. (Too bad for the Biden administration?) In terms of thin-air credit growth, the slowdown in it in years 2023 and 2024 (the blue bars in Chart 3 corresponding to the years 2025 and 2026) suggests that the GDP inflation rate should continue to moderate in 2025 and 2026, all else the same. Of course, all else is seldom the same. For example, an exogenous shock, such as the imposition of high tariffs in 2025 might cause a temporary increase in inflation in 2025 and 2026. Because a change in the inflation rate tends to occur two years after a change in thin-air credit, if the Fed were targeting growth in thin-air credit, it would need to be mindful of this lead-lag relationship in its current policy decision. For example, if the current rate of inflation were slowing, but if the current rate of growth in thin-air credit were increasing, then, based on historical relationships, the future rate of inflation would be expected to increase.

Let’s recap. In the past 70 years, the compound rate of growth in both actual and estimated potential real GDP has been, in round numbers, 3 percent. Now, add in a desired rate of inflation, or even, deflation, and you would have a desired rate of growth in nominal GDP. The behavior of thin-air credit appears to be relatively-highly correlated with the behavior of nominal GDP. Why not put the one thousand-plus economists employed by the Federal Reserve system to work on nailing down what growth rate in thin-air credit would result in the desired growth rate in nominal GDP? Having thin-air credit grow at the rate associated with the desired growth in nominal GDP would not eliminate periods of higher-than-desired unemployment or inflation because the economy is subject to various types of exogenous shocks, some predictable, some not. But, by having thin-air credit grow at a steady rate, monetary policy would not exacerbate the effects of these exogenous shocks. The business cycle would not be eliminated. But the amplitude of cycles would likely be moderated. If the Fed were to adopt a monetary policy that produced a steady rate of growth in thin-air credit, its communication problems would be solved. The Fed would simply announce its target growth rate of thin-air credit. It would be up to market analysts to determine what the level and term structure of interest rates would be, given the steady rate of growth the Fed was producing. Fed, don’t let the perfect be the enemy of the good.