Goal-setting and Central Banks.

Today the Federal Reserve, America’s central bank, will be concluding one of their regular meetings of the Federal Open Market Committee (FOMC), which sets monetary policy stance and actions for the Federal Reserve. After a speech at Jackson Hole, Wyoming, and due to strong hints in previous Fed minutes, there is widespread expectation of quantitative easing in their policy statement, to be released after the meeting on September 13th, 2012 at 12:30pm EST.

I thought I would take a moment to describe why this might or might not happen, and also what “quantitative easing” really means.

To start with, we should discuss what normal Fed actions look like. Whenever you hear about the Fed’s “interest rate”, the interest rate they are adjusting is the overnight lending rate between banks in the Federal Reserve system. The actual name is the Fed Funds Rate. Now, the Fed cannot just change that rate by dictum, so what they do is buy or sell short-term Treasuries until the overnight lending rate moves to their target.

Well, how does buying and selling short-term Treasuries change the overnight lending rate? When the Fed buys Treasuries, it does so by creating fresh money – “money printing” if you will, although no ink is actually used. And by increasing the supply of money, the relative scarcity declines, so lender banks are not able to charge as high of an interest rate for an overnight loan to another bank. And when the Fed wants to raise the interest rate, the opposite happens: Treasuries are sold back to the market, removing money from the banking system, increasing the relative scarcity of money, and banks find they can charge more interest for those overnight loans.

So that is how the Fed targets an interest rate. Well, what does quantitative easing mean?

Quantitative easing is essentially the same as regular monetary policy, but it happens when the overnight lending rate has already reached zero. When it appeared the U.S. economy was headed towards a recession in 2008, the Federal Reserve began to cut their target interest rate. They started at 5.25%, and by early 2009 they had lowered the target rate to between 0% and 0.25%. Essentially, zero!

Now what to do? The economy was clearly in free-fall. But with the Fed Funds Rate already at zero percent, many said the Fed had “run out of ammunition“. So instead of going into steady-state (maintaining the current rate), the Fed announced programs to buy large quantities of mortgage-backed securities and Treasury securities. Eventually this program would become known as “quantitative easing 1″ or QE1. The idea was to continue easing financial conditions broadly and reduce lending rates that were spiking in the economy by flooding the market with more money. And largely, it seemed to have worked to stop the fall, but didn’t create a recovery either. So while the Fed was watching for signs of a recovery, they stopped expanding the money supply. But by August of 2010, it became clear that inflation was falling and the recovery was faltering. On November 2010 the Fed formally announced that they would be purchasing an additional $600 billion over approximately six months, with the intent to foster lower lending rates, easier financial conditions economy-wide, and prevent price deflation. This would end up being called QE2.

What was most interesting was that in August of 2010, Ben Bernanke gave a speech at Jackson Hole, Wyoming, that strongly suggested the Fed would pursue more Treasuries purchases in order to help spur a stronger recovery. And on that very same day, interest rates on Treasuries started rising, inflation expections began to rise, and the stock markets rose. Wow! And the Fed hadn’t even *done* anything yet! Just on expectations of future policy, the market and economy moved *today*.

The Fed was beginning to learn the usefulness of explaining what they will do in the future to move the economy today.

So later in 2010 they also began to provide “forward guidance” for that Fed Funds Rate. The rate was at zero – but for how long? The Fed started committing to keep the Fed Funds rate low until late 2013. Eventually they moved that out to late 2014.

Still, this did not seem to move unemployment down or output up by very much. What is left?

This is where goal setting comes in. It’s one thing to say you are going to create $600 billion dollars. Should that expand the economy? Maybe, but will that money be pulled back as soon as inflation picks up? And likewise with the low interest rates “until 2014″ – is that unconditional, or could that be pulled back? Or is it a promise to raise rates after 2014? What if the economy has not recovered by then?  What should markets expect?

The Fed is slowly moving towards setting their forward guidance to be based upon an economic recovery. And this is the most effective policy the Fed can take – explicit targets. They could do it by engaging in quantitative easing until the economy returns to past long-run growth rate (about 5% year-over-year), or they could just promise to keep the Fed Funds rate low until the economy returns to the past long-run growth.  But the goal, the target is the key.

To build an analogy, let’s say I wanted to drive to Seattle. First I say I’m going to drive 600 miles, then stop and see if I made it. But I didn’t make it, so I say I will keep driving until late Friday. But I still didn’t make it. It appears my goals weren’t very conducive to making it to Seattle.

But if I set a goal to drive to Seattle, and continue driving no matter how many miles and days it took – that is a worthwhile and understandable goal. Because it isn’t about how far I want to drive, or about how long I want to drive, but it is the destination that’s key. And so it is with the Fed, they just need to indicate their destination. Let’s hope they do it.

Cashless economy?

There has been a bit of news lately about Sweden moving to become a cashless economy.  Their cash in circulation is only equal to 3.5% of their economy, which compares to 7% for the US for 9% on average for Europe.  Frankly, I am surprised the US is that low – I would have guessed more at 10%.

 Apparently, Sweden has recently introduced the near-field phone-based payment networks and those have furthered the trend of customers using card- or phone-based systems of payment.

Anyways, some of the advantages of cash-less systems are less risk of theft, lower costs of transporting cash (no need for security guards!), and ease of conducting payments. Another possible benefit is to make it more difficult to conduct bribes, since in an electronic system all transactions would have a record associated with them.

This gets to some of the disadvantages.  The first and primary is cash-less systems fail when there isn’t communication network access, or especially in locations without electricity.  Or in an emergency, when both of those situations can rapidly occur.

However, most of the developed nations have electricity and at least some form of cellular network available, so this is less of an issue.  Another downside is convenience – there are just certain transactions that are faster in cash.  Taxi cabs are one where they absolutely hate hate hate credit cards (often because they get hit with higher fees as high as 5 to 7 percent!). Or have you ever decided to pay for a $1.50 cup of coffee with a credit card?  Don’t be that guy!  With small purchases, the network fees eat up a larger proportion of the overall payment, hurting retailers.

But one of the biggest potential downsides may be this lack of privacy that cash provides.  I think people should have a way to pay each other anonymously, and no that doesn’t mean I favor illegal drugs or dealing in stolen merchandise.  I just see that having access to all payment transactions could be abused in the hands of an unfriendly government.  But others might not see this as big of an issue – do you?

But even in Sweden, there is some doubt that cash will entirely disappear, even at their Riksbank.  But the trend is moving away.  At any rate, I’m actually glad this isn’t happening here in the United States yet.  In fact, hearing about it makes me want to go pull out a bunch of cash and try to do a cash-only run for a while.  What about you?  Where do you think payment networks will go in the future?