In this 57 minute podcast titled How the Federal Reserve Works Trevor Burrus interviews George Selgin, a Senior Fellow and Director of the Center for Monetary and Financial Alternatives at the Cato Institute and professor of emeritus of economics at the University of Georgia. The link includes a transcript. (Recorded December 29, 2017)

« The Fed’s mandate [00:18:30] required it to … Both to avoid dramatic instability of the value of money … And substantial changes in that value, and also to limit unemployment, so the Fed had it as it were secular mandate, longer run mandate to make sure that the dollar didn’t depreciate too rapidly relative to goods and in a more cyclical mandate to make sure that we didn’t have cycles of unemployment- »

« Too much money, you get inflation, too little money, you get deflation. Too little money in the short run, you can get a downturn, a business downturn with unemployment until either the central bank makes up for the monetary shortage or prices adjust downward and end up on the newer equilibrium, but that’s a process fraught with difficulties. »

« so avoiding a shrinkage [00:21:00] in the flow of spending is important as a way of limiting business cycles, and unemployment, and deflation. »

« In equilibrium, there’s an equilibrium that’s the same as where you started, but the process of adjustment can involve some ways. So this is where we get this idea that a good central bank will manage things so that prices neither rise rapidly, nor fall rapidly, and cycles are avoided. But at bottom, it’s really about stabilizing, not prices per se, but spending. Keeping ‘em spending on a nice even [00:22:00] schedule. »

« Their objective, their immediate challenge is to see to it that the actual rate at which banks are borrowing from each other doesn’t deviate from that target. The way they would do that in the old pre-2008 days, was if the [00:24:30] rate … If the actual Federal Funds Rate tended to be rising above the target, let’s say above three percent, they would go out and purchase assets in marketplace, usually government securities, and they would pay for them with newly created deposit credits, Federal Reserve credits, and that would mean the bank reserve become more plentiful, and that would mean the supply of Federal Funds, right? Which is the reserves available for overnight lending would go up, and that should [00:25:00] lower the actual equilibrium funds, right? And help get the target…  »

« The idea is if the Federal Funds Rate is getting too high, that will also will tend to mean tightness and other lending markets, so in keeping it from rising, you’re also keeping those other rates from rising. Conversely, if the Fed [00:25:30] Funds Rate is sagging, that suggests that there’s not much demand for Federal Funds. You want to keep it at target, you’re gonna withdraw some reserves ‘cause evidently there’s more out there than banks need to sustain the target interbank rate. That’s how the system works, so it’s a combination of setting a target interest rate that you hoped was the right target, and then engaging in what are called open market operations, which is either buying government securities [00:26:00] in the open market and having the Fed buy these securities, or selling them, depending on whether they wanted to make reserves more available or less to achieve the target.  »

« I wouldn’t say that the process when haywire in the run up to the financial crisis. The financial crisis of course is a situation where you can have [00:27:00] an often typically do have an extraordinary demand for reserves, right? Because of panic, because of uncertainty, because of perceived risks of lending, so suddenly other things equal the tendency is for banks to clamp down on lending, including interbank lending, and for the demand to hold reserves to become extraordinarily high under those circumstances.

For a given Federal Funds Rate target, the challenge [00:27:30] of monetary policy becomes to supply that many more reserves to keep the target at the rate, at that target because otherwise it’s certainly going to tend to rise above. So in a way, there’s nothing different from a crisis situation, it’s business as usual, except that it’s a situation where in order to keep its target, a central bank has to create a lot more reserves than it normally would ever have to do, that is then [00:28:00] it would have to do on crisis time. »

«I think the Fed’s conduct was about right in light of these basic principles, [00:30:30] but then in 2008, things started to go quite haywire, and did so I think not just because the crisis becoming that much more severe, which it did, but because I think the Fed made some very serious miscalculations that actually in turn contributed to the severity of the crisis.. The mistakes I’m talking about are ones the Fed committed after the bubble breaks, which I believe it started to make some real mistakes in that case, some time in mid 2008.  »

« For some time, they set the target rate at two percent, which sounds very low and was low by historical standards and more typical norm would be four percent, twice that. However, in crisis situation, it can take a much lower target interest rate to avoid a downward spiral, and I think [00:33:00] in retrospect, it’s pretty clear that the two percent rate that the Fed was striving to maintain was too high. It only very reluctantly lowered that rate, first to 1.5% after the Lehman disaster and then eventually as low as  .25% or a range from zero to .25, but by that time it was too late, and indeed, even .25 was too high. »

« So there’s a lot to be said about how we could do better than the present Federal Reserve arrangement, but saying why don’t we just get rid of the Fed is not saying very much because it really just leaves [00:57:30] you with begging all kinds of questions about what sort of arrangement is supposed to fill that vacuum. So I think we have to think hard about how we can get from where we are to a better system and not just think about what we’d like to get rid of because that’s only half the story. »

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