Effem makes an important comment

The Fed can dictate the USD-denominated price of any asset. All the money in the world is but an insignifcant fraction of the amount of USD the Fed is able to print.

Is that not totally obvious?

This does seem obvious but it is at odds with the results of a competitive market equilibrium.

Suppose that the Fed tries to goes in and trillion dollars worth bonds at 10am on Tuesday morning. What happens?

Well, the price of bonds is driven way up. That’s of course the same as saying the interest rate is driven way down. For the purposes of this post I am going to speak in terms of bond prices rather than interest rates but keep in mind that the two are equivalent ways of discussing the same thing.

So, bond prices are driven way up. That’s going to get some people to start selling bonds who otherwise wouldn’t and some people to stop buying bonds who otherwise would.

In both cases money is being driven out of the bond market. Where does it go. Well some of it is going to go into other assets, stocks or oil futures for example. And, if you watch CNBC you can see that an announcement of more bond purchases by the Fed will immediately send stocks and futures prices up.

And, its important to note this happens immediately – within a few seconds thanks to computer trading. If it were possible for a computer to read and interpret a Fed statement reliably then the price of the assets would probably rise within milliseconds of the Fed statement being released. Its only the time it takes for human eyes to read and understand what is being said that slows this process down.

So here we are 10:02AM and stock and futures prices are rising. What does that do?

Well presumably it drives some people to sell who wouldn’t have and some people not to buy who would have. That is, money starts moving out of the stock and futures markets.

Where does it go?

It a perfectly competitive world it goes into the markets for real goods and services. People seeing higher stock prices realize that they are now richer and they can afford to buy a new car, or fancy dinner or something else.

However, because markets are competitive that immediately bids up the price of new cars and fancy dinners. Not only that but by the substitution effect it bids up the price of used cars and not-so fancy dinners. This in turn bids up the price of bicycles and food at the grocery store.

In fact, the price of every single thing in the country is immediately bid up as buyers move in and out of various markets.

Its now 10:05AM on Tuesday. The price of everything in America is going higher. That seems really too bad for people who weren’t in stocks and bonds in the morning because now they can’t afford stuff.

That is, except for the fact that all of these higher prices have no made every industry earn economic profits. The market abhors economic profits. And, so every industry attempts to expand to take advantage of those profits.

To do that they must hire more workers. Except when every single industry is trying to hire more workers at once, their won’t be enough to go around. Wages will have to rise. So want ads are all changed and everyone offers a higher wage than they were before. They also have to give higher wages to their existing workers or the existing workers will take a new offer somewhere else.

So now its 10:10AM on Tuesday and all prices and all wages in America have risen.

The price of bonds has risen as well, but the price of bonds in comparison to the price of everything else has not changed. The injection of money has simply lead to an increase in all prices, stocks, bonds, houses, gasoline, everything.

In this case money is simply a veil and the Fed has no traction over real bond prices.

Yet, we do think the Fed has traction over real bond prices? How is this possible? It must be that money is in some since not a veil which means on “some level” that prices are sticky.

Why they are sticky is up to dispute, but I am not sure how you write down a story of human economic behavior where prices move smoothly and the Fed has control over real bond prices.