Beginning of Series: Part I

Learning Loops and Examining Assumptions

History is littered with examples of people operating based on flawed assumptions. Fortunately, there is also a history of people challenging those assumptions. Operating using flawed assumptions over and over again can be referred to as single-loop learning. To challenge assumptions before proceeding, we refer to it as double-loop learning.

Maybe the time has come to apply some double-loop learning to our assumptions about the Federal Reserve System.

First Loop - Historic Assumptions

The historic assumptions upon which we base our first learning loop relate to:

total reserves
required reserves
and excess reserves

Based on our assumptions about these three elements of the Federal Reserve system, we could make reasonably accurate predictions about how The Fed activity would affect the money supply and interest rates.

Second Loop - New Assumptions About the Fed

Based on an examination of existing assumptions, we discover that there are new assumptions that also need to be examined:

The Fed Sets Interest Rates
The Significance of the Fed Funds Rate
The Fed Creates "Money"

We now realize that the Fed cannot set (or raise) rates, the Fed funds rate does not act as a base rate, and the Fed does not create money.

Time to Rethink Fed Assumptions?

After examining our assumptions about the Federal Reserve system, the time has come to rethink and create some new assumptions.

Can The Fed Set Fed Funds Rate?

The Fed cannot raise or set rates for the simple fact that interest rates or a dependent variable. Interest rates cannot be changed without changing either the quantity of dollars borrowed or the quantity of dollars lent.

The commonly general reference to "rates" should refer only to the Fed funds rate, which raises the question about the significance of the Fed funds rate.

What Significance Does Fed Funds Rate Have?

The Fed funds rate does not, and cannot, act as a base rate for the broader financial market. Fed funds trade in a closed market, and the rates for Fed funds transactions result from the actions of the future participants in that closed market.

Does The Fed Creates "Money?"

The Federal Reserve cannot "pump" money into the economy because it cannot force banks to create deposit liabilities with which they buy debt obligations. The Fed only has the power to create dollars that participants in a larger market cannot own.

Conclusion

Market commentators and analysts base their conclusions on flawed assumptions. The time has come for "Fed watchers" to check their assumptions.