Fed Has A Recursion Problem

Terra made two coins, Luna and UST, that depended on each other.  They both crashed recently.   I made the following graphic:

 

The Fed has a similar design problem.  The Treasuries are measured in US Dollars but the Fed backing for the US Dollar is mostly Treasuries.   In this kind of setup both parts can go to zero in terms of real world things.  

The Real Bills Doctrine says that if a bank loans out short term against real things that it can be safe.  But if a bank loans out long term in its own currency it can get into trouble.   This is very old wisdom.   Young folks today did not learn this stuff in school.  I think the Fed will be giving the world a demo on how this fails.

In computer science we would call this a recursion problem.  In computer science you can have a function that is defined in terms of itself but there needs to be a base case that does not need further recursion.  With Luna/UST or Treasuries/USD there is no base case.   So the results are "not well defined".   So it did not and will not end well.

Originally by law the dollar base case was gold.   The Fed originally had 40% gold backing and anyone could turn in $20.67 in dollars and get  1 oz of gold.   Then in 1933 only other countries could redeem dollars and only 1 oz gold for $35.  Then after 1971 no one could turn in dollars for gold.   In 1980 gold got up to around $850 per oz and the Fed still had enough that at that price their gold helped stabilize the dollar.

The Fed's Can Opener

The Fed talks as if "the neutral rate" is 2.5% and they just need to get the Fed Funds rate up to that and all will be fine.   As Larry Summers points out this is a logical error very much like the joke about economist assume we have a can opener. 

Joke from Wikipedia:  President Ronald Reagan told the joke to students and faculty at Purdue University on April 9, 1987 saying: "It seems an economist, a chemist, and an engineer were stranded on a desert island. And between them they had only a single can of beans, but no can opener. The engineer suggested that he climb a palm tree to a precise height, then throw the beans at a precise distance, at a precise angle. 'And when the can hits,' he said, 'it will split open.' 'No,' said the chemist. 'We'll leave the can in the sun until the heat causes the beans to expand so much the can will explode.' 'Nonsense,' said the economist. 'Using either method we'd lose too many beans. According to my plan, there will be no mess or fuss and not a single bean will be lost.' Well, the engineer and the chemist said, 'We're certainly willing to consider it. What's your plan?' And the economist answered, 'Well, first assume we have a can opener.'"

From transcript of Powell's May 4, 2022 press conference and video:

"And the current estimates on the Committee are sort of two to three percent. And also, that's a longer-run estimate. That's an estimate for an economy that's at full employment and two percent inflation. So really the way, really what we're doing is we are -- we're raising rates expeditiously to the -- what we see as the broad range of plausible levels of neutral."

They are assuming there is no inflation in their target estimate of the "neutral rate",  even though in the real world we have high inflation.  This is wrong.    It is like the joke, "first assume we have no inflation, then we just need to get rates to 2.5%".  

They have not given us an estimate of the neutral rate for the real inflation conditions we are in, let along a rate that would tame inflation. 

Their mandate is to maintain stable prices and in their plan they are just assuming  we have stable prices.  This is crazy bad.  They are not doing their job. They are not taking the tough steps needed to get from where we are to stable prices.  To lower inflation you need to get interest rates above the inflation rate.   In the real world we have high inflation and even 2.5% will still be a very negative real rate and so stimulative, not neutral.  Many months inflation has gone up 0.5% or more and the Fed has ruled out raising rates faster than that.   They are far behind and it is not clear they will ever catch up.  Runaway inflation is a real possibility.