Inflation VIII

 

Catch The Wind

For me to love you now
Would be the sweetest thing
That would make me sing
Ah, but I may as well, try and catch the wind

Raising the Prime Interest rate to control inflation may be trying to catch the wind

In being asked to control inflation by raising its interbank interest rates, the Federal Reserve Bank is using its primary function, to serve as the lender of last resort for private banks, in order to try to control random events. In doing so, it may doing more harm than good. The interest rate hikes may have contributed to private bank failures, and preventing bank failures is precisely why the Federal Reserve was created in the first place.

Banks exist to take existing liquid value and convert it to long term less liquid future streams of value. When that value, a currency/medium of exchange, is based on a commodity there is a problem. Using a commodity as the medium of exchange in economic transactions means that you have to store, safely maintain, and transport that commodity. When that commodity is gold, this is not a trivial issue. Gold is heavy. Banks started issuing notes that represented a certain amount of that commodity. But that imposed a burden of trust on parties when using those bank notes. Both the buyers and sellers in economic transactions have to trust the bank and the value represented by its note.

When a currency, the medium of exchange, is a commodity that crates problems when groups hoard that commodity, corner the market. Then only economic transactions by those parties can be accommodated, which is precisely the opposite of the purpose of a medium of exchange. Trading by barter requires that both parties want what the other has and value their goods the same way. Since you can’t always find such parties, medium of exchanges were used to measure the value of goods. When the medium of exchange is a commodity, like gold, it is a commodity currency, and as mentioned when groups hoard that commodity and will not participate in exchanges, then the number of economic transactions declines. That is why fiat currencies were developed that are not finite and the market can not be cornered. The fiat currency should be sufficient to allow economic transactions to take place, including any increases in value, and you have to trust that the party issuing that fiat currency. If they set it to an amount that is more than the economic transactions it must support,  such as with the Weimar Republic, hyperinflation can result. That is why national economies usually set their currency to the value of their economy, e.g. M2. If that was the only economic transactions that needed to be considered, then that should suffice. The problem trade between nations with their own currencies.

During World War II, it was realized that gold as the international trading medium of exchange,  could not accommodate international trade because almost all of the world’s gold was in the Untied States and an international fiat currency did not exist. During Bretton Woods, John Maynard Keynes proposed the creation of Bancor as the international fiat trading currency. The problem was there was as yet no trusted group to issue such a fiat currency. John Foster Dulles and the United States prevailed in an argument that the US Dollar, while a fiat currency domestically, would be convertible into gold for international trade, a commodity currency.

This dual status of the US Dollar, a fiat currency domestically and a commodity currency internationally, was maintained until the Nixon Shock of 1971. At that time, the US Dollar was became a fiat currency at home AND in international trade. However the dollars in circulation were only created to support the value of the US domestic economy, M2. There was no recognition of the value in international trade that was supported by the US Dollar. As domestic  US Dollars competed with international US Dollars, the result was inevitable as the high inflation of the late 20^th Century. Arguably the fiat value of  the US Dollar should be M2 + the USD used in international trading, MI. International trading has been increasing by 6-8 percent per year and the USD used in international trade, which according to the Society for Worldwide Interbank Financial Telecommunications, SWIFT, is approximately 50% of that trade. Thus the fiat value represented by the USD should be the current USD plus the change in M2 plus 50% of the change in MI. Measuring inflation over the last year includes changes in product inflation AND changes in currency inflation over the last year. While Year Over Year inflation has been declining and has been  as recently as 2020 been about 2%, long term inflation in  the CPI since 1971 has been about 4% per year. The pervasive inflation is because in those periods where random product inflation is zero or negative, there still has been an increase in currency inflation.

Arguably the Federal Reserve should only be concerned with currency inflation. However by setting the US Dollar only to accommodate the changes in M2, this ignores any changes in MI. It is proposed that the money supply of the US Dollar should recognize its use in MI. In this case, currency, medium of exchange, inflation should be zero. The problem is that inflation also includes product inflation. The Federal Reserve Bank tries to address product inflation by changing its Prime Inter-Bank Interest rate. In all honesty it can not do this. At best it can time-shift supply and demand, but it can not create or remove this supply or demand. The problem is that banks turn existing liquid value into illiquid future values. Withdrawals, if any, are from liquid reserves. If the withdrawals exceed the liquid reserves, then long term illiquid assets may be sold at a loss to turn them into liquid assets. If there are no buyers, or the loss is too great, then the bank fails.

A billionaire investor, e.g. Peter Thiel, withdraws his deposits/value from a bank, e.g. Silicon Valley Bank. While the bank has already converted his liquid value into streams of illiquid future values of a greater amount. However when each investor withdraws, that investor is allowed to withdraw liquid assets from the bank's reserves rather than receiving the converted illiquid value. The result may be a bank failure. The action precipitating the withdrawal may have been reduction of the future value of the stream of illiquid value because of the raising of interest rates. By continuing the fiction that the deposits have not already been converted and allowing them to be withdrawn from liquid reserves, the very act of raising the interest rates may have precipitated the bank failure that the Federal Reserve was created to prevent. You can change the impact of numerous random events. i.e. climate, setting the house odds. You can not control every random event, i.e. weather, each roll of the dice. Trying to do so is as futile as trying to catch the wind.