Recent Updates

  • US: Business Formation Statistics, Producer Prices (Jul)
  • US: Business Formation Statistics by State (Jul)
  • US: National Delinquency Survey (Q2)
  • US: 1ST Time Housing Affordability (Q2)
  • US: Producer Price Indexes Detail by Commodity Detail (Jul)
  • more updates...

Economy in Brief

Fed, First Do No Harm
Confirmation Hearings for Paul Kasriel's Nomination to the Federal Reserve Board of Governors

by Paul L. Kasriel  May 16, 2022

Senate Banking Chairman Senator Brown: This confirmation hearing will now come to order. Welcome Dr. Kasriel.

Mr. Kasriel: Before this hearing proceeds, may I submit a correction for the record. The only Dr. Kasriel I am aware of is my deceased second cousin, Robert Kasriel, who earned a doctorate in mathematics and went on to have a brilliant career teaching that subject at Georgia Tech. I never turned in a final draft of my PhD dissertation in which I investigated an obscure Federal Reserve policy called “even-keel policy”. I was attracted to this policy because I was and still am a sailor. We sailors try to keep our craft on a relatively even keel. My research concluded that there was no discernible difference between periods in which the Fed was pursuing an even-keel policy and periods when it was not. So, I do not hold a PhD, but rather an ABD, all but dissertation. That said, I do believe that my stay at a Holiday Inn Express does qualify me for consideration to serve on the Federal Reserve Board of Governors.

Senator Brown: Let the record show that the nominee is a mere “Mister” rather than a “Doctor”. Mr. Kasriel, I am intrigued by the written statement you submitted to this committee outlining your approach to conducting monetary policy entitled “Fed, First Do No Harm”. Could you briefly explain your thesis, not the one on Fed even-keel policy, but the one in your written statement to this committee?

Mr. Kasriel: Mr. Chairman, I am a great admirer of the writings of the late Professor Milton Friedman. Friedman argued that economies are complex, ever-changing “organisms” of which economists do not have sufficient knowledge to regulate with any meaningful precision at a macro level. There are lags, the lengths of which can vary and are unknown with, again, any meaningful precision, between when a central bank policy action is taken and when the full effect of such action on a targeted variable will occur. Moreover, economies are subject to relatively unpredictable “shocks” such as the Covid pandemic of 2020 and the Russian army's invasion of Ukraine on February 24, 2022. Both of these shocks had significant effects on the course of the US and global economies, the magnitudes and durations of which are not known. Friedman argued, and I believe history has borne out his argument, that the Fed often takes well-intentioned policy actions to mitigate an actual or perceived undesirable macroeconomic process only to find that these policy actions result in other undesirable macroeconomic processes. A case in point was the Fed's flooding the US economy with liquidity when the Covid pandemic hit the US economy in March 2020. The Fed rightfully feared that Covid-induced partial shutdown of the US economy could result in massive credit defaults in the private sector and the “freezing up” of the private credit markets. The Fed's actions prevented these consequences, but the Fed did not withdraw this liquidity in a timely manner, which has fueled the high inflation we now are experiencing. In essence, Friedman argued that well-intentioned Fed monetary policy actions tend to increase the amplitudes of business cycles. That is, Fed monetary policy actions tend to turn business expansions into booms and business slowdowns into more severe recessions. The upshot of this is that the Fed should operate monetary policy such that it first does no harm to the macroeconomy.

Ranking Member, Senator Toomey: Mr. Kasriel, are you suggesting that the Fed should keep the federal funds rate at its so-called “neutral” level?

Mr. Kasriel: Senator Toomey, that might be a good policy if the Fed actually knew at what level of the federal funds rate represented neutral. I would submit that the neutral level of the federal funds rate is not a constant through time. For example, when businesses perceive that capital investments will be more profitable, there will be an increased demand for credit. All else the same, the level of interest rates ought to rise. Even if the Fed were aware of this, it does not know by how much interest rates should rise. Demographics can play a role in determining the neutral level of the federal funds rate. As a population ages, households' demand for credit will ebb as they previously have borrowed to purchase a house and durable goods. All else the same, as a population ages, the neutral level of the federal funds rate would decline. Again, would the Fed know by how much the neutral level of the federal funds rate had fallen? Will all else be the same?

Senator Toomey, the Fed currently talks about hiking the federal funds rate “somewhat” above its neutral level in order to rein in inflation and achieve a “softish” landing. I would ask the Fed to specify what it perceives the neutral level of the federal funds rate to be under current conditions. As of June 24, 2022, the 30-day federal funds futures market contract 12 months out closed at a federal funds rate of 3.50%. Should we consider this to be the neutral level of the federal funds rate?

I don't pretend to know what is the neutral level of the federal funds rate. But I do know that historically, the federal funds rate tends to be above the consumer price inflation rate. Plotted in Chart 1, which I submitted to the committee, is the percentage-point spread between annual averages of the federal funds rate and the year-over-year percent change in the All-Items Consumer Price Index (the blue bars). From 1955 through 2019, the median spread was 1.24 percentage points. In 2021, the CPI inflation rate was 4.70% and the federal funds averaged 0.08%, which yielded a spread of minus 4.62 percentage points. Let's fantasize that the CPI inflation rate slows to 3% by the end of June 2023. Based on the long-run median percentage point spread between the federal funds rate and the CPI inflation rate, the federal funds rate would be 4.24% (3% plus 1.24 percentage points). This is a higher federal funds rate than the 3.50% that was priced into the federal funds futures contract 12 months from now as of June 24, 2022. The red line in Chart 1 represents the year-over-year percent change in annual average All-Items CPI. Notice, senators, when the percentage point spread between the federal funds rate and the inflation rate is negative, the inflation rate tends to be moving higher.

Chart 1

Senator Moran: Alright, Mr. Kasriel. You seem to be saying that the Fed is bound to do harm by implementing monetary policy through the setting of the federal funds rate. I get that. The federal funds rate is the price of overnight credit. I hail from the great State of Kansas where a lot of wheat is grown. My constituents follow the wheat futures markets intensely. They know that the price of wheat, like the price of anything else, is determined by ever-changing supply and demand factors. Try as one might, no one can know whether today's equilibrium price of wheat will be the same as tomorrow's. So, how do you suggest that the Fed should conduct its monetary policy?

Mr. Kasriel: As you mentioned you are from a state where agriculture is a key driver of economic activity. I have found that agricultural economists seem to have a better grasp of economic theory than those who specialize in other fields. When trying to determine how the Fed should conduct monetary policy, it is important to realize that Fed policy affects the nominal aggregate demand for goods, services and assets by people residing in the US. Fed policy actions do not change the aggregate real supply of goods and services.

I'm going to digress here, but please bear with me. Suppose I were a counterfeiter and, for some reason you came to me for a loan to purchase a tractor. After we agreed on the terms of the loan, as a counterfeiter, I would go in the backroom and print up some fresh counterfeit greenbacks. You might take these counterfeit greenbacks to your local farm implements dealer and use them to purchase a tractor. Your demand for tractors just increased. Did anyone's demand for anything else go down because of this transaction? No, I, the counterfeiter, just created greenbacks in my backroom. Now, contrast this with you going to one of your relatives for the tractor loan. I would be willing to bet the farm that none of your relatives are counterfeiters. Again, you and your relative agree on the terms of the loan. How will your relative fund her loan to you? She had been planning to purchase a new pickup truck in the near term. But the interest rate you agreed to pay her on the loan was high enough for her to defer her purchase of the new pickup. If she waited until you repaid the loan, the principal plus the interest she would receive later would enable her to purchase that new pickup with some additional options. So, your relative cuts back on her current intended purchases and transfers her purchasing power to you by writing you a check on her bank account. In this case, someone else's demand for goods and services did go down by the amount of your purchase of the tractor. So, there was no net increase in spending in this period.

Ok, let's get back to Fed monetary policy. I will never forget one of my former colleagues at the Chicago Fed, Tom Gittings, exclaiming at a staff meeting that the Fed was, in effect, a legal counterfeiter. By that he meant that the Fed has the ability to create greenbacks figuratively out of thin air. To understand this, let's assume that the Department of Defense wants to replenish its supply of munitions after having transferred some of its inventory to Ukraine. The US Treasury is going to issue some bonds to fund these Defense Department purchases of munitions. To simplify matters, let's assume that the Fed is allowed to purchase these bonds directly from the Treasury. (Normally this is not allowed. The Fed is permitted to only purchase Treasury securities in the secondary market. But this is a distinction without a difference.) So, the Fed purchases securities from the Treasury, credits the Treasury's “checking” account at the Fed by the amount of the securities purchase, the Treasury then writes a check on this account at the Fed to US manufacturers of munitions and the Defense Department gets additional munitions. From where did the funds come to credit the Treasury's Fed account? The Fed created these funds figuratively out of thin air. Thus, the Fed is acting as a legal counterfeiter. The Defense Department was able to increase its current purchases and no one else needed to cut back on their current purchases. The funds created by the Fed out of thin air resulted in a net increase in domestic nominal spending.

The banking system is an accomplice to the Fed's legal counterfeiting activities. Suppose the treasurer of Company One calls its bank, Bank A, seeking a $100 loan. Company One's treasurer and Bank A's loan officer agree on the terms of the loan and Company One's account at Bank A is credited by $100. Company One purchases $100 worth of widgets from Company Two, paying for the widgets by writing a check for $100 on its account at Bank A. Company Two deposits the check for $100 at its bank, Bank B. Bank B then presents the $100 check written on Bank A for payment. Bank A does not have an extra $100 sitting around, so Bank A bids for $100 in the interbank overnight funds market, the federal funds market. Assume that no other banks have $100 in idle funds either. So, Bank A's demand for $100 puts upward pressure on the federal funds rate. But, because the Fed is targeting the level of the federal funds rate, it needs to add to the supply of funds in the federal funds market if it does not want the federal funds rate to rise above the Fed's targeted level of the rate. So, the Fed purchases $100 of securities in the open market, which injects $100 into the federal funds market. Where did the Fed get the $100 to pay for the securities it purchased? You guessed it senator, the Fed created $100 figuratively out of thin air. This $100 injection of funds into the federal funds market relieves the upward pressure on the federal funds rate. Bank A borrows $100 from, say, Bank C in the federal funds market, transferring the $100 to Bank B for the check Bank B presented to it.

To summarize, Bank A extended $100 of credit to Company One, enabling Company One to purchase $100 of widgets from Company Two. Did any entity have to cut back on its current purchases so that Company One could increase its purchases by $100? No, because the funds enabling Company One to increase its purchases were created figuratively out of thin air by the Fed and the banking system working in tandem.

What if Company One floated $100 of commercial paper to finance its intended purchase of widgets? Perhaps a money market mutual fund purchases Company One's commercial paper. Where does the money fund get the dollars to purchase this commercial paper? Typically, households purchase shares in a money fund and the money fund then purchases commercial paper and other short-maturity debt instruments. Where do households get the funds to purchase money fund shares? Some households save, that is, do not spend all of their income. Some of household current saving is used to purchase money fund shares. Again, the act of saving is to delay current spending and to transfer one's current purchasing power to another entity that currently has a greater desire to spend currently. The abstinence from current spending is rewarded by interest income paid by the borrower. So, in this case of Company One's sale of commercial paper to a money fund, Company One increases its spending whilst the new purchasers of money shares cut back on their current spending (i.e., they save). There is no net increase in spending because there are no new funds created out of thin air.

For those of you senators who have not nodded off, the point of this digression was to demonstrate the unique power the Fed and its accomplice, the banking system, have in influencing the behavior of aggregate nominal domestic spending via the creation of credit figuratively out of thin air.

Now, allow me to empirically verify this. Consider Chart 2, which is included in my written comments submitted to you earlier. The blue bars in Chart 2 represent the year-over-year percent changes in annual averages of real (or price-adjusted) final sales to private domestic purchasers. Final sales exclude purchases of inventories. I would have preferred to use real private domestic total purchases, but alas, the Bureau of Economic Analysis does not publish a price index for this. Why domestic final sales? Because the creation of credit out of thin air by the Fed and the banking system affects domestic spending, not foreign spending on our exports. Why private final sales? Because the government is going to spend whatever it wants to spend. Back to Chart 2. The red line in Chart 2 represents the year-over-year percent changes in the annual average of the sum of real credit extended by depository institutions (primarily commercial banks now) and real credit created by the Fed, which is the monetary base (reserves held by depository institutions at the Fed and currency in circulation). As I explained in my digression above, credit created by the depository institution system and the Fed is credit created figuratively out of thin air. So, think of the red line in Chart 2 as the year-over-year percent changes in the annual averages of real, or price-adjusted, thin-air credit. Starting in 1955 and through 2019, the correlation between these two series is 0.60, which is shown in the upper left-hand little box in Chart 2., where “r” stands for the correlation coefficient. The fact that there is not a minus sign in front of “0.60” indicates that these two series are positively correlated. That is, when the red line moves up, the blue bars also tend to move up, and vice versa. The magnitude of this positive correlation is 0.60. If these two series were perfectly correlated, the magnitude of the correlation coefficient would be 1.0.

Chart 2

Senator Kennedy: Let me interject, Mr. Kasriel, a correlation coefficient of 0.60 is not bad for government work, but correlation does not necessarily mean causation.

Mr. Kasriel: A correlation coefficient of 0.60 is not too bad for private sector work either, Senator Kennedy. I can detect your Oxford training, Oxford, England, not Mississippi, when you bring up the notion that correlation does not necessarily imply causation. It could be that changes in real domestic private final purchases are causing the Fed and the banking system to create changes in real thin-air credit in the same direction. Alternatively, it could mean that changes in real thin-air credit are causing changes in real domestic private final purchases in the same direction. That is why when I run correlation studies, I lead and lag the variables against each other to see what happens to the correlations. I found that when changes in real thin-air credit lead by one year, the value of the correlation coefficient falls to 0.29. When changes in real final sales to domestic private purchasers lead by one year, the value of the correlation coefficient declines to 0.40. So, it is difficult to tell from correlation studies which variable “causes” the behavior of the other since correlation values decline from the value of the correlation coefficient when both variables are examined contemporaneously.

I should explain why I terminated the examination period at 2019. As you are well aware, because of Covid, the US economy contracted significantly in 2020 in both nominal and real terms. This was because of the partial shutdown of commerce globally. At the same time, the Fed created massive amounts of nominal and real thin-air credit. But if the global economy cannot produce goods and services because a large part of the labor force is not allowed to report for work, an infinite increase in thin-air credit will not result in a significant increase in the global production of goods and services for the private domestic sector to purchase. Thus, if the examination period were extended through 2021, the value of the correlation coefficient would decrease significantly because of the 2020 negative Covid supply shock. But I conclude that if the Fed could control the growth in real thin-air credit, it would have relatively good control over the growth in real private domestic demand for final goods and services, barring supply shocks, either positive or negative.

Senator Scott: Mr. Kasriel, my constituents right now are concerned about inflation inhibiting their purchases of real final goods and services. If your nomination for a seat on the Federal Reserve Board of Governors were to be confirmed by this committee, what policy or policies would you recommend to constrain consumer price inflation?

Mr. Kasriel: Senator Scott, the late Professor Milton Friedman stated that inflation is always and everywhere a monetary phenomenon. By “monetary” Professor Friedman was referring to a monetary quantity. Professor Friedman's preferred monetary quantity was some measure of currency plus bank deposits held by the nonbank public. My research suggests that my concept of thin-air credit, that is the sum of credit created by the Fed plus credit created by depository institutions, has a more reliable association with consumer price inflation in the post-WWII era than do various measures of the supply of money favored by Friedman. Moreover, the “transmission” mechanism for thin-air credit is more intuitive. Entities usually borrow in order to purchase something – a good, a service and/or an asset. So, in most cases, if thin-air credit increases, almost assuredly, some entity is increasing its current nominal spending on something. The money supply transmission mechanism is wonkier. When the money supply increases, then the issue is whether the increase in the money supplied is greater than the supply of money demanded by the public. And the demand to hold a certain amount of money is determined by myriad factors such as income, the explicit/implicit yield on money relative to other assets. In other words, the demand to hold a given supply of money is part of general equilibrium portfolio theory. If the supply of money is greater than what is demanded by the public, then the public increases its purchases of goods, services and assets until explicit/implicit yields on everything come back into equilibrium. Senator Scott, I see your eyes and those of your fellow committee members' eyes glazing over. Rightfully so. But the notion that an increase in thin-air credit implies that some entity is most likely borrowing in order to increase its current spending is more intuitive than portfolio theory, isn't it? Before leaving Friedman's explanation of inflation being a monetary phenomenon, ask yourself this question: In a pure barter system, that is a system in which there was no money, could there be any inflation?

Senators, I now refer you to Chart 3 in the written statement I submitted to you. The blue bars in Chart 3 represent the year-over-year percent changes in annual averages of the nominal sum of depository institution credit plus Fed credit or thin-air credit. The red line in Chart 3 represents the year-over-year percent changes in the annual averages of the chain-price index for final sales to private domestic purchasers. Notice that changes in thin-air credit are advanced by two years, meaning that the percent change in thin-air credit in a given year is associated with the percent change in the price index, or inflation rate, two years hence. Thus, unlike the association between percent changes in real thin-air credit and percent changes in real final sales to private domestic purchasers, which tends to be coincident, percent changes in nominal thin-air credit tends to lead changes in the inflation rate by two years. As you can see by looking at the little box in the upper left-hand box in Chart 3, the correlation between these two variables is positive with the value of the correlation coefficient being 0.60 over the period from 1955 through 2019. Again, if the correlation were perfect, the value of the coefficient would be 1.0. I examined the data with the inflation measure leading percent changes in the thin-air credit. The value of the correlation coefficient declined in these cases. Thus, there is prima facie evidence that current changes in thin-air credit, a monetary quantity, cause future inflation.

Chart 3

To summarize, senators, my research suggests that changes in real thin-air credit are positively associated with contemporaneous changes in real private domestic demand for goods and services. And, nominal changes in thin-air credit are positively associated with future rates of inflation. Some economists have suggested that the Fed try to control and target the growth in nominal aggregate demand. The idea would be to have consumer price inflation run at a rate of about 2% annually and have real aggregate demand run at an annual rate equal to some estimate of the economy's potential to produce real goods and services. Let's say that the Fed chooses a target of annual growth in nominal aggregate demand of 5%, assuming a 2% annual inflation rate and a 3% annual growth in the potential growth in the real availability of goods and services. Because of the different lags involved in the growth of thin-air credit and its effect on real aggregate demand growth and consumer-price inflation, the Fed would be wise to try to pick a rate of growth in nominal thin-air credit that it believes is roughly consistent with its target of 5% annual growth in nominal aggregate demand and stick with it. From 1955 through 2019, the median year-over-year percent change in nominal final sales to domestic private purchasers was 6.3%. Median thin-air credit growth was 0.8 percentage points higher, or 7.1%. So, a back of envelope estimate of the target range for the annual growth rate in thin-air credit growth might be 5-3/4% to 6%. What if there were a negative supply shock, such as a pandemic, that rendered growth in the real potential supply of goods and services lower than 3%? If the 5% growth in thin-air credit were maintained, then the consumer price inflation rate would settle in at some rate above 2%, but the inflation rate would not spiral higher and higher. Conversely, what if there were a positive supply shock, such as the advent of some new technology, that rendered growth in the real potential supply of goods and services higher than 3%? In this case, consumer price inflation rate would eventually trend lower than 2% if the 5% growth in thin-air credit were maintained. Would that be so bad? The bottom line is that errors would not cumulate if a steady rate of growth in thin-air credit were maintained in the face of random shocks to the economy.

Senator Shelby: Mr. Kasriel, I'm a fiscal conservative for a number of reasons, one of which is that I believe fiscal profligacy results in higher inflation. Do you not concur that runaway spending authorized by the Democrat Congress and implemented by the Democrat Biden administration is largely responsible for today's high inflation rate?

Mr. Kasriel: No Senator, I do not concur with your assertion that the sharp increase in federal spending that has occurred during the Biden administration is the principal cause of our current high inflation. Again, to quote Professor Milton Friedman: “Inflation is always and everywhere a monetary phenomenon.” When the federal government increases its spending, it has to fund these increased expenditures. The federal government has only two sources from which funding can come, increased taxes and/or increased issuance of debt, neither of which, in and of themselves, increase the quantity of thin-air credit. In both cases, some entity's current spending will decrease whilst the federal government's spending increases. Thus, net spending in the economy will not change as a result of the increase in federal government spending. If taxes are increased, the payers of these taxes are forced to either cut back on their current spending or sell assets. The sale of assets would cause the buyers of these assets to cut back on their current spending. If the government issues new debt, the purchasers of this debt would have to cut back on their current spending in order to fund their purchases of the debt. However, if the Fed, for whatever reason, decides to increase the quantity of thin-air credit in response to the increase in federal government spending, then net nominal spending in the economy will increase, all else the same, and higher inflation could occur, with a lag. But it is not the increase in federal government spending that causes increased net nominal spending in the economy and eventually higher inflation. Rather, it is the Fed's creation of additional thin-air credit that causes the higher net nominal spending in the economy and the following higher inflation. If the Fed did not allow thin-air credit to increase, net nominal spending would not increase. Rather, the structure of interest rates would tend to rise.

When the federal government issued checks to many US households in response to anticipated loss of their income due to Covid in both the Trump and Biden administrations, the Federal Reserve and the banking system essentially credited households' bank accounts with funds created figuratively out of thin air. Thus, households could increase their current spending whilst no other entity need cut back on its current spending. Covid did retard the growth in available goods and services. So, too much thin-air credit chasing too few goods and services resulted in higher inflation.

Senator Sinema: Mr. Kasriel, my constituents are very concerned about the skyrocketing prices of food and gasoline, which your economist brethren cleverly exclude when calculating your so-called “core” inflation rate. How can monetary policy bring down the prices of food and gasoline?

Mr. Kasriel: Senator Sinema, I have never endorsed the concept of core inflation nor do I think the Federal Reserve should use it to guide its policy decisions. The only price the Fed can directly influence is the price of credit, i.e., an interest rate. Fed monetary policy is a blunt instrument that affects nominal aggregate spending. In turn, growth in nominal aggregate spending in relation to the growth in the real aggregate supply of goods and services affects the rate of consumer inflation.

Although the Fed cannot control the price of any specific good or service, it can influence the growth in nominal aggregate demand such that growth in a general price index stays in a desired range. Let's say that some group of petroleum producers decides, for whatever reason, to cutback its production. This would cause the price of petroleum products to increase. If the Fed does not change the growth rate of thin-air credit, growth in nominal aggregate demand would not change. But purchasers would use more of their nominal income to purchase the same or few units of petroleum products whose price has risen. This would leave less nominal income for purchases of non-petroleum products. The shift back in the demand curve for non-petroleum goods and services would establish a new lower equilibrium prices for these goods and services. Thus, although the prices of petroleum goods would rise, the prices of other goods and services would fall. This would keep the general price index unchanged or its rate of growth unchanged. There would be a change in relative prices, the prices of petroleum products relative to the prices of non-petroleum goods and services, but not a change in the general price index. Of course, the prices of non-petroleum goods and services would not decline instantaneously.

In the hypothetical above (Mr. Kasriel muttered something barely audible to the effect that most senators refuse to deal in hypotheticals proposed by the press), the real potential growth of the economy would be reduced. With a reduced supply of petroleum, a key production input, aggregate production would be reduced. Until the prices of non-petroleum goods and services decline along with the nominal wages in these industries, the unemployment rate would rise. This is unavoidable if the Fed is to control the behavior of the general price index. To generalize, in order to prevent the general price level from rising in the face of negative supply shocks, the Fed must forgo the “funding” via increases in thin-air credit of the increase in the relative prices of goods and services in short supply because of the negative supply shock.

Senator Crapo: Mr. Kasriel, consumer price inflation has been relatively low in the past three decades compared with the prior three decades. Some economists explain this in terms of increased Fed credibility in keeping inflation low. That is, because market participants believe the Fed will act to keep inflation low, inflation expectations are kept low. And if people do not expect inflation to flare up, they will not act in a way so as to cause inflation to flare up. Do you agree with this explanation of the behavior of inflation in the post-WWII era? If so, does the recent high inflation imply that the Fed has lost its credibilty?

Mr. Kasriel: I believe the primary explanation for the behavior of consumer price inflation in the post-WWII era has beeb the behavior of thin-air credit. The Fed has never targeted thin-air credit. For a few years during Fed Chairman Volcker's tenure, the Fed paid lipservice to targeting various definitions of the money supply, a monetary quantity akin to thin-air credit, but this attempt was not very effective for a variety of reasons and was shortlived. So, if the Fed gained and maintained any credibility as the guarantor of low inflation, it was because it inadvertently slowed down the secular growth in thin-air credit.

Let's look at Chart 4 in the written statement I submitted to the committee. The blue bars in Chart 4 are the year-over-year percent changes in the annual averages of the sum of depository institution credit and Fed credit (the monetary base), or thin-air credit. The red line is the year-over-year percent changes in the annual averages of the Personal Consumption Expenditure (PCE) Chain-Price Index. From 1955 through 2021, the mean, or average, year-over-year percent change in thin-air credit was 7.2%. But if we break this period down into two subperiods, we observe much different thin-air credit growth rates in each period. From 1955 through 1988, the mean growth rate in thin-air credit was 9.0%. From 1989 through 2021, the median growth rate in thin-air credit slowed to 5.5%. Looking at PCE inflation in these two subperiods, the average was 4.2% from 1955 through 1988 and 2.1% from 1989 through 2021. So, the consumer price inflation rate was cut in half in the second subperiod while the growth rate in thin-air credit declined by about 40%. So again, I suggest that the primary reason consumer price inflation has been low from about 1989 through 2019 is that there was a marked slowdown in the growth of thin-air credit. Given that the Fed was not targeting thin-air credit or even knew what thin-air credit was all about, it is difficult for me to accept the notion that it was Fed credibilty that has kept inflation low up until 2021. As I explained earlier in my testimony, the current inflation flareup is due to the Fed allowing growth in thin-air credit to explode in the face of the negative supply shocks of the Covid pandemic and the Russian invasion of Ukraine.

Chart 4

Senator Reed: Mr. Kasriel, if I understand you correctly, you are ascribing today's elevated consumer price inflation rate to the Fed's creation of excess amounts of, in your terms, “thin-air” credit. But the Fed began its quantitative easing (QE) policies during the Great Recession and for some years thereafter, which created a lot of thin-air credit but did not result in elevated inflation. How do you reconcile this difference?

Mr. Kasriel: For starters, the current period differs from that of the Great Recession and the immediate years thereafter in that there were no negative supply shocks to the global economy in the former period in contrast to those that did occur in the current period. As I argued in my prior testimony today, a negative supply shock combined with growth in total thin-air credit above its 1955 through 2019 average of 7.1% is a recipe for a sharp escalation in the rate of consumer price inflation. But even more important is that although the Fed did create a lot of thin-air credit during and after the Great Recession, the depository institution system did not. So, the growth rate in total thin-air credit, the sum of depository institution credit and Fed credit remained quite low in an historical context. This is observable in Chart 5 that I submitted in my written statement to the committee. The green bars in Chart 5 are the year-over-year percent changes in annual averages of the Fed's direct contribution to thin-air credit. The red line represents the year-over-year percent changes in the annual averages of depository institutions' contribution to thin-air credit. And the blue line represents the year-over-year percent changes in the annual averages of total thin-air credit, the sum of depository institution credit and Fed credit. Notice that in the three years ended 2011, depository institution credit actually contracted. So, even though the Fed, by itself, was creating large amounts of thin-air credit via its intermittent QE policies through 2014, the mean growth rate in total thin-air credit was only 4.1% from 2008 through 2014 compared with 7.2% from 1955 through 2021. This is why the Fed's QE policies from 2008 through 2014 did not result in elevated consumer price inflation rates.

By the way, had I been a governor on the Federal Reserve Board I would have argued for even more aggressive QE policies during the 2008 through 2014 period to supplement the relatively weak growth in depository institution credit. Depository institution credit growth was weak during this period because many institutions could not extend much credit because of capital inadequacy resulting from losses incurred during the residential real estate bust. Depository institutions today are well capitalized and are creating credit at relatively high rates.

Chart 5

Senator Kennedy: Mr. Kasriel, you have given us an extensive argument as to why you think the Fed should target and, implicitly, try to control your so-called thin-air credit. But you have not given us a number for the targeted growth rate of thin-air credit. Let me tell you about economic forecasting. There are 300 PhDs and economists at the Fed, and not a single one of them called a meltdown in '08. Economic forecasting around the Fed in the last 15 years makes those psychic hotlines look reputable. So, I can understand why you have not provided us with a number.

Mr. Kasriel: Senator Kennedy, as I mentioned at the outset of this hearing, I do not possess a PhD in economics or anything else. So, I do not know whether my forecasting accuracy is any better or worse than those 300 PhD economists in the Federal Reserve System. I will note, however, that I was warning about the coming collapse of Main Street as well as Wall Street starting in 2005. Also, in the spring of 2021, I was warning that the higher inflation being experienced then was not transitory and that the Fed was falling far behind the inflation “curve”. But hey, Senator Kennedy, even an olfactory-challenged hog finds an acorn occasionally.

The title of my written statement is “Fed, First Do No Harm”. I am basically recommending that the Fed attempt to stabilize the growth in nominal thin-air credit at some rate consistent with 5.3%% annual growth in nominal final sales to domestic private purchasers. The compound annual growth in real final sales to domestic private purchasers from 1955 through 2021 has been 3.3%. Add on a 2% annual inflation target, you get 5.3%. From 1955 through 2021, the compound annual growth rate in nominal thin-air credit has been 0.7 percentage points above that of the compound annual growth rate in nominal final sales to domestic private purchasers. Thus, I would recommend that the Fed try to maintain annualized growth in nominal thin-air credit at 6% (5.3% plus 0.7%). If the Fed were able to maintain annualized growth in nominal thin-air credit at 6% and growth in real final sales to domestic private purchasers turned out to be higher than its long-run rate of 3.3%, then inflation would likely turn out to be less than 2%. Would that be such a bad thing? If growth in real final sales to domestic purchasers turned out to be lower than its long-run rate of 3.3%, then inflation would likely turn out to be higher than 2%. But inflation would not spiral to higher and higher rates. But, Senator Kennedy, perhaps those 300 PhD economists at the Fed could refine my back-of-the-envelope target for thin-air credit growth. If I am confirmed as a Fed governor, one of the first projects I would assign my staff, if I were given a staff, to work on would be to come up a recommended target growth rate for thin-air credit.

Senator Warner: Mr. Kasriel, what has been the behavior of your thin-air credit concept in recent months and what are the implications for the economy and inflation of its behavior?

Mr. Kasriel: Senator Warner, the recent behavior of a narrower definition of thin-air credit is shown in Chart 6 of my written statement submitted to this committee. Regrettably, the Fed publishes data for my concept of total thin-air credit only on a quarterly basis with a significant lag. For example, Q1:2022 total thin-air credit was only made available on June 9, 2022. The Fed-credit component of thin-air credit is available weekly. But total depository institution credit is available only quarterly with that lag I talked about. However, the largest component of depository institution credit, commercial bank credit, is available on a weekly basis with a one-week lag. So, these are the data plotted in Chart 6. The blue bars are the 26-week annualized percent changes in the sum of commercial bank credit and the monetary base (Fed credit). In the 26 weeks ended June 15, 2022, this narrower definition of thin-air credit contracted at an annualized rate of 2.6%. This marks quite a deceleration from its annualized rate of 13.6% in the 26 weeks ended December 29, 2021. The red line in Chart 6 represents the 26-week annualized percent changes in weekly levels of commercial bank credit. In the 26 weeks ended June 15, 2022, commercial bank credit grew at an annualized rate of 9.0% compared with 10.8% in the 26 weeks ended December 29, 2021. So, the behavior of thin-air credit is not the primary component of thin-air credit accounting for its sharp deceleration in its percent change from year-end 2021 to mid-year 2022. The principal factor accounting for the sharp slowdown in the growth of this narrower definition of thin-air credit is the behavior of the monetary base or Fed credit. In the 26 weeks ended June 15, 2022, the annualized percent change in the monetary base was minus 29.2% compared with plus 21.4% in the 26 weeks ended December 29, 2021. The slowdown in the monetary base growth is due to the Fed's “tapering” of its purchases of securities. Now the Fed is letting its outright holdings of securities decline. So, all else the same, the monetary base is likely to continue to contract, which would also lead to a contraction in this narrower definition of thin-air credit. The recent behavior of this narrower behavior of thin-air credit is not consistent with my view of the Fed doing no harm. The Fed has allowed thin-air credit to grow far in excess of its long-run average rate starting in March 2020 and much below its long-run average rate in the past 26 weeks.

Chart 6

Regarding the recent behavior of thin-air credit, because changes in real thin-air credit and changes in real private domestic demand tend to occur contemporaneously, we would expect to observe relatively weak growth in real domestic private aggregate demand in the coming quarters. But because there is about a two-year lag between a change in nominal thin-air credit and its full impact on the rate of consumer price inflation, we should not expect to see a significant decline in the rate of inflation in the next several quarters. To Professor Friedman's point, the Fed's actions are tending to increase the amplitude of the business cycle. Rather than doing no harm, the Fed is amplifying harm to the macroeconomic environment.

Senator Ossoff: Mr. Kasriel, your recommendation that the Fed target the growth in thin-air credit is interesting. When I was studying at the London School of Economics, we read some articles on the Austrian theory of the business cycle especially works by Friedrich Hayek, who had been on the faculty in the 1930s. Your concept of thin-air credit sounds like something Hayek discussed. It is all well and good for the Fed to target something, but how would the Fed have to operate to come close to hitting its target rate of growth of thin-air credit?

Mr. Kasriel: Senator Ossoff, you are correct about my concept of thin-air credit being related to Hayek's work. Thin-air credit is right out of the playbook of the Austrian theory of the business cycle. I simply put a name on it.

In order for the Fed to control the growth in thin-air credit, it would have to impose a reserve-requirement ratio on the earning assets of depository institutions. Up until recently, the Fed imposed a reserve-requirement ratio on the deposits of depository institutions. Deposits are liabilities of depository institutions. Earning assets, as their name suggests, are assets of depository institutions, which are on the other side of the balance sheet. The Fed would also need to eliminate interest it pays on reserves held by depository institutions at the Fed. Senator Ossoff, I am sure you learned at the LSE about the reserve multiplier in describing how an injection of a certain amount of reserves by the Fed results in some multiple of that amount of deposits being magically “created” in the depository institution system. Those deposits get created by depository institutions advancing credit, i.e., by granting new loans and/or purchasing securities. So, the Fed would increase/decrease its creation of reserves by a certain amount and, depending on the value of the reserve-requirement ratio, depository institution credit would increase/decrease by some multiple of the amount of reserves the Fed added/drained. A former Chicago Fed colleague of mine, Robert D. Laurent, who suffered an untimely death on June 30, 2005, came up with an ingenious way for the Fed to control the of supply deposits in the depository institution system. He described this proposal in an article in the August 1979 edition of the Journal of Money, Credit and Banking, entitled “Reserve Requirements: Are They Lagged in the Wrong Direction?”. I am sure those 300 PhDs at the Fed could modify Laurent's proposal so that the Fed could hit its thin-air growth target in or near the bullseye.

Senator Tester: Mr. Kasriel, where I come from a monopolist, like the Fed, can either control the price of something or the quantity of that something. You stated earlier that the only price the Fed could control directly was the price of credit, i.e., some interest rate. If I understand your recommendation that the Fed to control the quantity of thin-air credit does this not imply that the Fed would then relinquish its control of an interest rate? And if so, would this not imply that there would be increased volatility in interest rates?

Mr. Kasriel: Senator, you are spot on, as my former Northern Trust boss Perry Pero, May He Rest in Peace, used to say. (Mr. Kasriel muttered something inaudible along the lines of this guy is really sharp. Maybe he should run for president.) So, Senator Tester, we would be getting increased volatility in interest rates for decreased volatility in the growth of nominal domestic aggregate demand. In my opinion, that's a pretty good tradeoff.

Senator Warren: Mr. Kasriel, if you came down from your academic ivory tower, would you not agree with me that today's high inflation is the result of bad old-fashioned corporate greed! Haven't big corporations just used the negative supply shocks induced by the Covid pandemic and the Russian invasion of Ukraine as cover to raise their prices?

Mr. Kasriel: Senator Warren, I would first ask that if corporations can raise their prices at will, why would they need to wait for negative supply shocks to do so? And if they can raise their prices at will, what determines the limit as to how high they can raise them? I am reminded of an old joke that pertains to this issue. John walks into Joe's Butcher Shop and sees that Joe is charging $6 a pound for ground beef. John complains to Joe about his high price and says that Sam's Butcher Shop is advertising ground beef at $3 a pound. Joe responds by saying that when he does not have any ground beef to sell either, he lowers his price to $3 a pound, too. So, Senator Warren, I would respond to your hypothesis about corporate “greed” by saying that sellers of goods and services always want to raise their selling prices, but competition limits their ability to do so. By the way, that goes for sellers of labor services, too.

Chairman Brown: Mr. Kasriel, before the committee votes on your nomination, would you like to make a brief closing statement?

Mr. Kasriel: Thank you, Chairman Brown and other members of the Senate Banking, Housing, and Urban Affairs Committee. In my opinion, the macroeconomy is a complex “organism”, affected by many factors that, given our current knowledge, are very difficult to predict with any precision. Moreover, as Professor Friedman used to remind us, the lags between a change in monetary policy and its major impact on the macroeconomy are variable, again, which we are unable to know with much precision. So, with our imperfect knowledge about the workings of the macroeconomy and the effects of monetary policy on it, monetary policy should be conducted in a manner to first, do no harm. The Fed should try to not contribute to the variability in the behavior of the macroeconomy. If the Fed operates by setting some interest rate that is far from its equilibrium or “neutral” level, then Fed policy will result in cumulative undesirable macroeconomic outcomes. However, if the Fed operates to achieve a steady rate of growth in thin-air credit, even if that rate of growth is “incorrect”, at least there will not be cumulative macroeconomic errors. I want to emphasize that if the Fed were to operate so as to achieve a steady rate of growth in thin-air credit, there still would be macroeconomic booms and busts, but the Fed would not be responsible for increasing the amplitude of these business cycles. Lastly, I would like to say that monetary policy is a blunt instrument that primarily affects aggregate nominal demand. Monetary policy is not the policy to address income-distribution or racial/ethnic/gender inequality issues. These issues should be addressed via legislation passed by the Senate and the House. This concludes my comments and I await the committee's vote on my nomination.

Chairman Brown: Mr. Kasriel the committee has unanimously decided to not confirm your nomination to the Board of Governors of the Federal Reserve for two reasons. The first reason is that we could find no evidence that the Biden administration ever nominated you for a Fed governor seat. The second reason is that we believe that if your monetary policy operating procedure were ever implemented there would be much less variability in macroeconomic outcomes. If the consumer-price inflation rate and unemployment rate were relatively low and steady, this committee would have no need to conduct hearings on these issues. Without hearings, we would be deprived of grandstanding for our constituents and we would have no excuse for not passing meaningful legislation to address issues for which monetary policy is not appropriate. I hope that you continue to enjoy your retirement, Mr. Kasriel. This hearing stands adjourned.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.
close
large image