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The Fed is Starving Economy of Interest Income

Warren Mosler
Tuesday, 24 Jan 2012 | 9:39 AM ET
Traders work in the ten-year U.S. Treasury Note options pit at the Chicago Board of Trade in Chicago, Illinois, U.S.
Daniel Acker | Bloomberg | Getty Images
Traders work in the ten-year U.S. Treasury Note options pit at the Chicago Board of Trade in Chicago, Illinois, U.S.

The Fed again deserves low marks for another year of being part of the problem rather than part of the answer.

For 2011 the Fed has again failed to address the interest income side of its policies.

For example, the Fed turned over approximately $80 billion last year to the Treasury, and probably a lot more this year with its larger portfolio, with no mention that the same $80 billion would have otherwise added that much to the income of the rest of the economy.

It would serve public purpose if the Fed made it clear that in today's rate environment, what's called 'quantitative easing' in fact removes interest income from the private sector, thereby functioning much like a tax and a source of what's called fiscal drag, as it takes net dollars out of the economy as it reduces the federal deficit.

Furthermore, all the evidence so far indicates this source of fiscal drag may be at least offsetting any positive effects of lower interest rates on aggregate demand.

This brings up my second criticism with regards to the interest income channel. Lowering rates in general in the first instance merely shifts interest income from 'savers' to borrowers. And with the federal government a net payer of interest to the economy, lowering rates reduces interest income for the economy.

The only way a rate cut could add to aggregate demand would be if, in aggregate, the propensities to consume of borrowers was higher than savers. But fed studies have shown the propensities are about the same, and, again, so does the actual empirical evidence of the last several years.

And further detail on this interest income channel shows that while income for savers dropped by nearly the full amount of the rate cuts, costs for borrowers haven't fallen that much, with the difference going to net interest margins of lenders. And with lenders having a near zero propensity to consume from interest income, versus savers who have a much higher propensity to consume, this particular aspect of the institutional structure has caused rate reductions to be a contractionary and deflationary bias.

The Fed should know this. There is a very high quality research paper by DC Fed officer Seth Carpenter spelling outmuch of this in detail for the FOMC, as well as research papers from the NY Fed on the same subject.

There is no question in my mind that the Fed has ample evidence to question their presumption that given today's institutional structure lowering rates and quantitative easing may have been counter productive and made things worse as per the interest income channels.

Yet they continue to unconditionally voice the opinion that they have been 'easing' with those 'accommodative' policies, to the point of promising more of same as additional tools to support aggregate demand.

(Read more from Mosler at MoslerEconomics.com. To find out more about Mosler’s background, click here.)

Warren Mosler is one of the founder fathers of Modern Monetary Theory, a heterodox school of economic thinking the breaks from both classical and standard Keynesian economics. This is the first of a three part series by Mosler looking at the Fed from an MMT perspective.

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