A few commenters was puzzled by my instance on sticky prices or some other mechanism specific mechanism for allowing the Fed to control short term interest rates.
This is actually an extremely important stylized fact that we only briefly touched upon in my debate with Bob Murphy. Its really important because of how obvious and straight forward it seems to market participants but how counter it is to basic economics.
The problem is this. Sure the Fed can print a lot of money and use that to buy bonds but why should that effect the relative price of bonds? The Fed isn’t changing anything fundamental about the bond market. What it is changing is the supply of money. The only thing that should change is the relative supply of money.
Well, because the response to price is imbedded in the mind of each market participant. The market price simply emerges. This will be critical later.
So when the Fed starts buying bonds it doesn’t change anything about the actual preferences of market particpants or the real constraints they face. It simply pumps more money into the bond markets.
That money will cause some bond buyers to refrain from buying bonds and some bond sellers to sell more bonds. Those particpants end up with more money which they spend elsewhere.
And, indeed we can see that within moments of the Fed announcing its intention – its mere intention – to buy more bonds, the price of stocks and futures contracts will begin to rise. That’s money going out of bonds and into stocks and futures, on the anticipation of Fed action.
The larger question is – why doesn’t money spill out into every market right away: houses, cars, groceries, clothes, etc. In fact, we think that it will eventually and that’s how money creation ends up fueling inflation. People try to buy more of everything, but there isn’t more and so the price must rise.
Yet, if all markets were as smooth as stock markets then this would happen immediately. The price of everything would rise, all the money the Fed tried to pump into the bond market would bleed out and bonds would be left the same as they were before.
Money would be a veil and doubling of the money supply would simply lead to a doubling of the price level, end of story.
That is not, however, what happens.
At minimum it takes time for prices to rise. Most don’t move nearly as fast as stock and futures prices. Moreover, it really seems like output rises as well. Perhaps that’s a measurement problem but at minimum something is happening.
How that something happens is a question that needs to be answered because it can’t be done with simply perfectly competitive markets. Such markets should act exactly like stock and futures markets. They should respond instantly to Fed movements and then be done. No lagging effects. No change in output. No alteration of interest rates.
It has been mentioned that bond traders can’t undue Fed action because they don’t know what the real price “should be.” However, the point of emergent order is that no one knows what the price should be.
The price is whatever results from individual buyers and sellers acting on their own preferences and constraints. The Fed doesn’t do anything to fundamentally alter these preferences and constraints – at least in a perfectly competitive economy – and so it cant do anything to alter bond prices.
Sellers keep selling based on their attempts at profit maximization and buyers keep buying. If you try to pump this system up with artificial money demand then the demand should simply spill out to the rest of the economy, rise all boats and leave relative prices unchanged.