Friday, January 8, 2021

Supply, Demand, and a Society in Crisis

September 2019 saw some brutal moves in interest rates. There was a shortage of US dollars, and the Fed was forced to either buy assets directly from the market, or let interest rates float to their natural levels. Predictably, the Fed chose to buy assets in the open market, and this has been its policy ever since. However, the Fed is again trying the impossible. It is signalling an intent to reduce its direct purchases while keeping interest rates down.

This means that the Fed is either ignorant of basic economic laws or lying. There's no way to keep both the supply and price of money down at the same time without slamming demand for money lower as well. With the Fed powerless to lower demand, their stated intent is doomed to failure, as explained here. The only way to succeed is to create some event that lowers demand for money, and that can only be done through political means, which a supposedly independent Fed is prohibited from doing.

One way to keep a lid on demand for money would be to create a societal crisis. The pandemic that came shortly after the spike in interest rates in September 2019, was in this respect convenient for the Fed. Something similar will have to be engineered for the Fed to mop up excess liquidity without sending interest rates higher. But this too is likely to fail. People have already cut back on consumption. Demand for money cannot easily be managed any lower.

Making things worse for the Fed is the fact that much of the money currently being sent into the economy is going towards debt repayments. People are fearful of the future, and therefore eager to get out of debt. This has the effect of lowering the money supply. Money becomes scarce, and the price of money goes up, exactly as it did back in 2019. Even with free money being handed out to people, the total money supply is likely to remain steady.

Without free money being handed out, things will be even more difficult to manage. Desperation will make people extremely reluctant to lend at the current low rates. People will want to pay down debt even more than now, and those lending money to people will demand much higher rates.

While the pandemic was able to temporarily suppress demand for money, a similar crisis today is unlikely to work. Destroying people's livelihoods is a trick that can only work once. There's a limit to how low demand can be managed lower through destruction. Once that limit is reached there's no longer any way to keep supply down without seeing prices rise. The Fed must either increase the money supply or let interest rates go higher. It cannot both reduce its direct purchases and keep interest rates down. Its stated intent is doomed to failure. It may even fail spectacularly, with both interest rates and money supply going up simultaneously, because a failure of the Fed to make good on its intent to keep money supply down will signal impotence. There will be a realization that all US debt will be inflated away, and that a dollar lent to the US today will be paid back in dollars of less value in the future. Interest rates will have to go up in order to entice lenders. But that will in turn force the Fed to print more money in order to keep interest rates from exploding higher. A vicious circle is thus created, and this will end either with the Fed giving up on keeping interest rates low or the Fed destroying the dollar completely.

Seal of the United States Federal Reserve System.svg

By U.S. Government - Extracted from PDF version of the Federal Reserve's Purposes & Functions document (direct PDF URL [1])., Public Domain, Link

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