Category: Economics

Bosnia

In my last blog I condemned the US’s illegal attack on Venezuela and worried about what might follow given the apparent lack of a broadly considered and agreed plan. In this blog I will contrast it with the approach taken at the end of the vicious civil war between the Croat, Serb and Bosnian populations of Bosnia and Herzegovina.

The fighting in Bosnia and Herzegovina ended with the signing of the Dayton accords. “Three decades ago, in November 1995, the U.S.-brokered Dayton accords ended the Bosnian war, a three-and-a-half-year ethnic conflict that killed roughly 100,000 people and displaced two million. The settlement imposed a complex power-sharing structure on a divided country, promising the state of Bosnia and Herzegovina a new start.” This quote is from an excellent assessment of that agreement and the new constitution for Bosnia and Herzegovina that it created by Elmira Bayrasli in Foreign Affairs: “Bosnia’s Unfinished Peace”

I drafted the monetary section of that constitution, which established a central bank bound by currency board rules (i.e. no monetary policy as the money supply is determined by the public’s demand for and willingness to purchase its currency). I also led the IMF teams that drafted the Central Bank Law that merged the existing three central banks (Croat, Serbian and Bosnian) into one national bank and currency. The negotiations with the three (obviously) future governors of the Central Bank of Bosnia and Herzegovina (CBBH) lasted for over a year of heated discussions of the CBBH’s powers and the details of its currency notes. For details see my account in “One Currency for Bosnia”  Surprisingly to many the CBBH’s currency board rules were accepted instantly by all three with no debate. The reason was that the three didn’t trust one another and currency board rules eliminate an monetary policy discresion.

The Dayton accord was the product of intense negotiations between the Presidents of Croatian, Serbian and Bosnian provinces of B&H and diplomates from the US, UK, EU and Russia culminating with the agreement at the Wright-Patterson Air Force Base in Dayton Ohio—the Dayton Accord. To lay out the sharp contrast between these negations and the lack of them in the current “take over” of Venezuela, I will quote extensively from Wikipedia:

“During September and October 1995, world powers (especially the United States and Russia), gathered in the Contact Group, pressured the leaders of the three sides to attend settlement negotiations; Dayton, Ohio was eventually chosen as the venue.

“Talks began with an outline of key points presented by the US in a team led by National Security Adviser Anthony Lake in visits to London, Bonn, Paris and other European stops 10 – 14 August 1995. These included Sochi, to consult Russian Foreign Minister Andrei Kozyrev. Lake’s team handed off to a separate US inter-agency group led by Assistant Secretary of State Richard Holbrooke, who went on to negotiate with Balkan leaders in their capitals. The Holbrooke crew conducted five rounds of intense shuttle diplomacy from August to October, including short conferences in Geneva and New York that resulted in the parties’ adoption of principles for a settlement on 8 and 26 September respectively.

“The Dayton conference took place from 1–21 November 1995. The main participants from the region were the President of the Republic of Serbia Slobodan Milošević (whom the Bosnian Serbs had previously empowered to represent their interests), President of Croatia Franjo Tuđman, and President of Bosnia and Herzegovina Alija Izetbegović with his Foreign Minister Muhamed Šaćirbeg.

“The peace conference was led by US Secretary of State Warren Christopher, and negotiator Richard Holbrooke with two co-chairmen in the form of EU Special Representative Carl Bildt and the First Deputy Foreign Minister of Russia Igor Ivanov. A key participant in the US delegation was General Wesley Clark. The head of the UK’s team was Pauline Neville-Jones, political director of the Foreign and Commonwealth Office. The UK military representative was Col Arundell David Leakey. Paul Williams, through the Public International Law & Policy Group (PILPG) served as legal counsel to the Bosnian Government delegation during the negotiations.”

The history and situation of Bosnia and Herzegovina was dramatically different than Venezuela. Ending its civil war required extensive negotiations and considerable international oversight of compliance to the agreed arrangements. As noted in the Foreign Affairs article sighted above, a serious mistake was holding national elections far too earlier. The intense hatreds of the three national groups were not given enough time to soften resulting in the election of hardliners and the continuation of the war by other means. The second mistake was the failure of international oversight (the UN High Representative) to fully exorcise its powers. None the less the three nation country has held together peaceably for three decades following its civil war.

While the political situation in Bosnia remains fragile (see the excellent article sited above in Foreign Affairs) the central bank itself has been a great success, widely trusted and respected by most citizens from the three provinces. I attribute this to its enlightened leadership and the central bank law with its currency board rules. Tragically the DOGE chain saw seems to have eliminated US capacity for effective diplomacy. “At the breaking point”

Econ 101: Bank Deposits and Stable Coins

I have always been fascinated by the details of money and payments and written a lot about it. “Econ-101: Money”  With the introduction in the US of dollar Stable Coins and potentially the retail (bank operated) version that might be established by our central bank (Central Bank Digital Currency) I find it interesting to compare how a payment with a dollar stable coin is executed relative to a payment with a dollar bank deposit.

The totally safe foundation of the dollar are the liabilities of the Federal Reserve Banks (we have twelve of them). These liabilities are currency (Federal Reserve Notes) and deposits banks have with their district Federal Reserve Bank, so called reserve deposits. Here in Washington DC our Fed is the Federal Reserve of Richmond. These two Fed liabilities (C+R) together are referred to as High Powered or Base Money.

As explained in my “Econ 101: Money” blog linked above, when you pay someone for a purchase with a check (or electronic payment order) drawn on your bank, the recipient does not accept an increase in their account at your back because they will almost certainly have their deposits in their own bank and deposits in banks do face the small risk of the bank failing and not being able to honor its deposits. Your payment from your bank deposit will be transferred to your payee’s bank and their deposit account via the debit of your bank’s deposits with the Fed and credit of the payee’s bank’s Fed deposit. When your payment is thus “settled” your obligation has been fulfilled and the seller has no further claim on you. Your bank deposits are ultimately claims on the Fed.

Payment of dollar Central Bank Digital Currency (if the Fed ever creates it) is a different story. Your transfer of your CBDC dollars to the seller is the whole story. Your CBDC (whether issued by your bank or directly by the Fed) is a direct claim on the Fed. Transferring it directly to the seller gives the seller a direct claim on the Fed. Thus, no other transactions are needed to provide the seller will the full certainty of such a claim.

Dollar stable coins issued by different banks or other financial enterprises are more like our VISA cards which are issued by around 15,000 different institutions. Mine is issued by United Airlines. Merchants who accept payment via any of these VISA issuers do so because of their confidence in the VISA network’s commitment to reliably delivering payment to the merchants bank account. It remains to be seen whether all or most stable coin issues achieve the same confidence and thus universal acceptance that the accepting party can redeem them for a dollar deposit to its bank account. Regulations that establish virtual certainty that dollar stable coins are fully and safely banked by liquid dollar assets will be essential. Such backing will enable any recipient of such a stable coin payment to redeem it for a deposit to the recipients own bank account.

A similar issue existed back in the days of currency notes issued by commercial banks. When they were accepted far from the issuing bank, they generally were given a lower (discounted) value. The issuance of National bank notes ended in 1935 when the newly established Federal Reserve System acquired a monopoly on bank note (currency) issue.

How to be Safe

Much can be said about how and why almost everyone on earth has risen from poverty to affluence. Two of the most important are free markets that allow entrepreneurs to invent and build, and peace and security that allow our work to build consumer goods and services rather than weapons of war.

Taking the second of these, the safety of our persons and our property allows us to specialize and trade – an absolutely critical condition for flourishing. The more broadly we can trade the greater is the wealth producing potential of our efforts. So a key question and the focus of this blog is how we maximize our safety in order to maximize trade the production of consumer goods and services rather than weapons of war.

Since 9/11 almost one million people have been killed in wars and when including indirect deaths from wars the number rises to around 4.5 million. The U.S. alone has spent over $21 trillion dollars on defense since 9/11.  This is 5.25% of the U.S.’s cumulative GDP over that period of $400 trillion.

If we could trust every country in the world, we could get rid of our military complex and add that amount to our incomes. Obviously that would be unrealistic thus some defense spending will always be necessary. However, with the deployment of skillful diplomacy it can be greatly reduced and the losses from actual wars could potentially be eliminated.

We must live among other people. If we are good neighbors, we will be safer from attacks (verbal or worse) by those around us. Being a good neighbor requires being trustworthy (honest) and behaving in ways that take into account and respect the interests of our neighbors. What is true on the block and village is true globally as well. The adoption of mutually agreed rules/norms for our interactions with others is an important aspect of our safety and productivity.

Within each country, at least, agreement has been reached on which side of the road to drive, what frequency we can broadcast on, and what voltage our electricity will be. Across boarders we have agreed on setting dates and time (the calendar), airline overflight rules, and the orbits our satellites will occupy. After WWII, in addition to the UN and its many agencies, NATO, the World Bank, the IMF, and World Trade Organization, countries established the International Organization for Standardization (ISO), International Telecommunication Union (ITU), and the International Electrotechnical Commission (IEC). Moreover, the US and most every other country have established embassies in each other’s countries in order to serve the needs of their own citizens abroad and to maintain dialog and informed relations with each other’s governments.

An important part of soft power diplomacy are the supportive relationships with “allies” who contribute to mutual defense, thus lowering its cost. But good (cooperative) relationships in general are an important contributor to our safety and commercial interaction with other countries. To a large extent formal rules of war and treatment of others have promoted peace in the world.

Violating these rules (e.g. Russia’s invasion of Ukraine and U.S. invasion of Venezuela) raises the cost of our security. It makes us less safe and less wealthy. https://wcoats.blog/2026/01/03/war-2/

President Trump has angered our friends and allies with his tariff and other threats and a generally bullying approach to our relations with other countries. He has created enemies where we didn’t have them before. After bombing Venezuela and kidnaping its President, he is now threatening the same for Cuba, Panama, Columbia, Iran, and Greenland. Denmark’s government, which controls Greenland’s foreign affairs and defense, has told the White House to “stop the threats.”

Protests of US lawlessness is growing. As but one example:

JOINT DECLARATION BY THE GOVENMENTS OF

BRAZIL, CHILE, COLOMBIA, MEXICO, SPAIN, AND URUGUAY

“The governments of Brazil, Chile, Colombia, Mexico, Spain, and Uruguay, in light of the gravity of the events that have occurred in Venezuela and reaffirming their commitment to the principles enshrined in the United Nations Charter, make the following joint declaration:

“We are deeply concerned and reject the military actions unilaterally carried out on Venezuelan territory, which infringe fundamental principles of international law, in particular the prohibition of the use and threat of force, and respect for the sovereignty and territorial integrity of States, as enshrined in the United Nations Charter. These actions set an extremely dangerous precedent for peace and security in the region and endanger civilian populations.”

Trump has isolated the U.S. by breaking the rules and angering our friends and alias. We are much less secure than in the past.  WP: “Venezuela-Trump-Global Law and Order”

Econ 101: Insurance

Insurance pools the costs of unpredictable events (illness, car accidents, etc.) so that the members of the pool share the costs of the events that fall on individual members of the group. Insurance that covers the costs of medical expenses incurred by a few members of the group (the insurance pool) is share among the group. Thus, most members of the group pay a “modest” amount for medical costs they do not incur in order to help pay the costs of care actually incurred by a few.

Your medical costs depend on many things. If you are paying for it, what you receive (and its cost) is agreed between you and your care giver (doctor). If someone else is paying for it, such as your insurance company, they will determine what is provided and its cost. An insurer can specify the doctors you must use with whom they will have agreements on cost and extent of treatment. Or you might choose your own doctor outside the insurers network, but the insurer will set the cost they will pay and potentially the extent of treatment they will pay for.

The fact that medical care is insured does not mean that the cost of providing it does not exist. The details of what the insurance covers can significantly influence the care given and its cost. As insurance is the sharing of the actual or covered costs with a group, the determination of who is in the group (pool) that will share whatever insured costs are incurred is critical.

When health insurance is provided by companies to their employees, the pool consists of those employees.  This has some advantages and disadvantages. It avoids packing the pool with sick people (e.g. those with preexisting health conditions) and thus increasing the cost to be shared (covered by the insurance). But it will generally result in the loss of insurance coverage if you want to change jobs. Forming insurance pools other than via an employer is an interesting challenge. An insurance pool of bird watchers might expect different premiums than a pool of mountain climbers.

Insurance providers attempt to keep the overall cost to be shared, and hence the cost of the insurance premiums, as low as possible by requiring the members of the pool to pay some amount (copay) of the medical bill thus providing them with some incentive to only get care that they really need. Price transparency is also important in this regard. A medical doctor friend complained to me that he doesn’t even know what his patients are being changed for his services. The approach that maximizes your incentive to economize on your medical expenses is to limit insurance to major medical expenses. Once again, the insurance company rather than the patient will negotiate the charges involved (hospital stay, medications, procedures, etc.).

Clearly what medical services are provided, and how that service is organized and its cost, will be significantly influenced by who pays for them. The policy challenge is to enable everyone to receive the essential medical care they need, while keeping its cost as low as possible overall and to each of us individually.

America First

What does America First really mean and how can we best achieve it? It should mean pursuing a foreign policy—our relations with other countries—that best serves our national interest. That requires that our relations with other countries maximize our security and our ability to profitably trade with them including traveling and vacationing in them. In short, our own interest is best served by having friendly relations with our neighbors. It serves our interest for others to trust us and to interact with us on the bases of known and shared rules. Tourism in the US is one of our best exports both in terms of revenue and its contribution to mutual understanding. Sadly, these goals have been seriously damaged over this year leaving us less safe and poorer than we could have been.

I am reminded of the debate over whether companies should strive to maximize profits (shareholder value). As John Mackey, a co-founder of Whole Food, has insightfully argued, a firm’s profits are maximized (assuming the government is not protecting its monopoly) when its workers, neighborhood, and customers are treated well and kept happy with the most efficient cost possible of supplying whatever the firm supplies. We might call this the right way to serve Shareholders First. Supporting this or that charity or cause should be left to the individual shareholders, who are likely to choose to give to different causes.

Econ 101: Interest rates

President Trump wants the Federal Reserve to lower interest rates thinking that that would reduce the interest the Federal Government pays in interest on its debt, which this last year was $1.13 trillion (yes trillion). Prior to 2008, the Fed’s policy interest rate—the so called Fed funds rate—was the overnight rate on overnight (i.e. one day) loans between banks. I will skip how the Fed determines (brings about in the market) that rate. Since 2008, when the Fed started to pay interest on bank reserves (deposits at Federal Reserve Banks), the Fed’s policy rate has been the rate paid on bank reserves.

The interest rates paid on longer (than overnight) loans (e.g., one, two, ten-year bonds) are related to the overnight rate because rolling over overnight loans for ten years is an alternative to a ten-year bond. This note explains that relationship.

The interest rate on, say, a one-year bond reflects what the market (lenders and borrowers) expects the one-day rate to be each day over that period. That, in turn, depends on what the market expects the “real” rate to be plus the rate of inflation. Market rates reflect the real rate plus the inflation rate. If inflation increase, other things equal, market interest rates increase.

So, the interest rate on a ten-year bond will reflect what the market expects the overnight rate to be over the next ten years, which reflects the expected real rate and the expected inflation rate over that period. So what happens to interest rates (say the ten-year bond rate) when the Fed lowers its policy rate as President Trump wants? It depends primarily on what that does to the market’s expectation of inflation over the relevant future period.

On Wednesday Dec 10 the Fed reduced its policy rate .25% to 3.50 to 3.75%. On that day the ten-year bond rate fell from 4.19% the day before to 4.15% but by Friday (two days later) had returned to 4.18% In short the ten year Treasury bond rate is essentially unchanged by the quarter percent drop in the Fed’s policy rate. Why? Because the market expects the drop in the overnight rate to be largely offset by a slight increase in inflation over the next ten years.

If the Fed is correct that lowering its policy rate is appropriate for continuing the reduction of inflation to its 2% target, then the ten-year rate will fall as well. Clearly an excessive cut in the policy rate (one that increases the expected rate of inflation) will increase longer term interest rates rather than lower them. Class dismissed.

Trade

Without trade each household/family would have to be self-sufficient, i.e., would only have to consume what they themselves could make, grow or do. No one would doubt the dire poverty the world would endure. Even trade limited to your neighborhood, with each household specializing in a few things to trade with other families specializing in other needs or wants would significantly increase everyone’s income. The wider the range of trade the greater the degree of specialization and increased income possible.

Expanding the potential for trade requires the ability to transport goods and serves over longer distances. The benefits of such connectedness extend well beyond higher incomes. Quoting from George Will’s wonderful book The Conservative Sensibility: Referring to the:

“Erie Canal. [Dewitt] Clinton [the sixth governor of New York] saw this project as a means of preventing states in the West from detaching themselves from the Union. The canal would “bind the union together by indissoluble ties” because the people would be “habituated to frequent intercourse and beneficial inter-communication,” and all Americans would be “bound together by the golden ties of commerce and the adamantine chains of interest.” The canal also, and inadvertently, helped to bring down the old order in Europe. By bringing cheap wheat from America’s Great Plains, the canal struck at the roots of Europe’s landed aristocracy.”

Implicit in the above is private ownership of one’s production. People work hard for their own benefit but to benefit from trade they must take account of the needs and wants of others. Trade must be win-win or it will not take place. I benefit from selling my production and you benefit from buying it. Communism—communal production—lacks the personal (selfish) incentive to work hard and has broadly failed as a system. Also from George Will: “In China, once collective farms were disbanded in 1978 under the leadership of the reformer Deng Xiaoping, agriculture output doubled in the space of just four years.”

The topic of trade keeps returning and I have written about it often. Rather than repeat myself, yet again, I will share some of those earlier blogs:

Econ 101—Trade in very simple terms
The politics of Trade
Econ 101: Tony Judt on Trade

Stable Coins

Digitizing our bank deposits (digital dollars—stable coins) would (will) represent another step forward in the ease and efficiency with which we can make payments and will enhance bank stability. Most of the US supply of money (US dollars) is in the form of our dollar deposits at our banks and most of our payments these days are already made by electronically transferring bank deposits from me to you via my bank to yours. I have discussed all of this in more detail earlier: “Econ 101-Money”

Developing the rails for paying with stable coins is a further improvement on our existing payment options. It is not revolutionary. The payment of cash (currency) requires no infrastructure (e.g. Merchant contract with credit card issuer and card reader, etc.). You just hand it over and anyone can accept it (hopefully the person you intended to receive it). The electronic transfer of a bank deposit balance (e.g., Zelle, Venmo, e-wire) requires the enrollment of the recipient in that particular payment vehicle.  It took decades for credit cards to be widely accepted. Hundreds of companies now issue Visa cards (mine is issued by United Airlines) and all are accepted wherever any of them are accepted. But it took a lot of work to build that system.

What do stable coins issued by banks add that might be useful? From the bank side issuing stable coins from deposit balances simplifies the bank’s management of the assets that back them. When its customers withdraw cash these days, the bank must purchase it from the Federal Reserve in order to pass it on to you. It pays the Fed for the cash from its reserve deposits at the Fed, which reduces its ability to extend credit to businesses and households. If its reserves at the Fed are not sufficient, it will need to borrow from another bank or sell another asset.

The withdrawal of cash from bank deposits tends to follow seasonal patters. Thus the squeeze on its reserves at the Fed would tend to create seasonal fluctuations in bank credit hence in the money supply.  Thus the Fed attempts to offset the impact of currency fluctuations on bank reserves and thus credit with offsetting purchases and sales of government securities (so called open market operations) or with temporary loans to banks in its “lender of last resort” function. If a bank can issue its own currency (as they did in the old days) when a customer withdraws cash from its deposits, its asset backing (and reserve deposits at the Fed) will not be affected. Banks will now be able to do this by issuing their own stable coins. While the customer’s deposit balance will fall when withdrawing cash (or stable coins), its total of stable coins “cash” plus deposit balance will not change thus the bank assets backing them do not need to change. Thus, such fluctuations in the currency/deposit ratio would not product a fluctuation in the money supply.

From the customers side the stable coins are as good as traditional cash only to the extent that the infrastructure to accept them (e.g. phone wallets) has been designed and widely acquired/accepted. Just as it took many years for credit cards (Visa, Mastercard and American Express) to be widely adopted, the same will be true with stable coins. Just as you might now swap addresses via your respective mobile phones, you will be able to make payments.

If everyone can issue their own money it degenerates to barter, i.e. it would not be money at all. The essence of a successful means of payment is the certainty of its ultimate claim on the central bank’s official monetary liability (the dollar). When central banks were limited to issuing currency redeemable for “something” such as gold or silver, the amount they issued was limited by their holding of gold or silver, etc.  Today the Fed’s supply of money is limited by Congress’s mandate for price stability and full employment. And ultimately the government must accept such dollars in payment for our tax obligations stated in the same currency.

Miracle of the grape

A few weeks ago I posted a note on Facebook  on the grapes I had for breakfast:

https://www.facebook.com/share/p/1TVFzjuche/

I called it a miracle but failed to mention a very important aspect of the miracle, namely the development of such delicious and resilient grapes in the first place.  Grok provides the missing information

Thompson Seedless grapes, also known as Sultana, were developed through a combination of natural selection, selective breeding, and modern agricultural practices that enhanced their sweetness and resilience. Here’s a breakdown of how they became what they are today:

Origins and Natural Selection

  • Historical Background: Thompson Seedless grapes trace back to an ancient variety called the Sultana, originating in the Mediterranean or Middle East. This grape, scientifically Vitis vinifera, was naturally seedless due to a genetic mutation called stenospermocarpy, where seeds fail to develop fully, resulting in small, seedless berries.
  • Introduction to the U.S.: In 1872, William Thompson, a California nurseryman, introduced this variety to the United States from Europe. He promoted it as a superior grape for table use and raisin production, naming it “Thompson Seedless” after himself. The grape’s natural seedlessness was a key trait that made it appealing, as it improved eating quality.

Selective Breeding and Cultivation

  • Selection for Sweetness: Over generations, farmers and breeders selected vines that produced sweeter, larger, and more uniform berries. This was done through:
    • Clonal Selection: Growers propagated cuttings from vines that exhibited desirable traits, such as higher sugar content (measured in Brix). Thompson Seedless grapes typically have a Brix of 18–22, indicating high sweetness.
    • Crossbreeding: While the original Thompson Seedless was not heavily hybridized, its cultivation alongside other grape varieties in California allowed for natural adaptations and minor genetic improvements over time.
  • Resilience Through Grafting: To enhance resilience, Thompson Seedless vines were often grafted onto rootstocks resistant to pests like phylloxera (a root-destroying aphid) and nematodes, as well as tolerant to various soil conditions. This practice, common in California’s vineyards by the late 19th century, improved the vines’ durability against environmental stresses.

Modern Agricultural Practices

  • Irrigation and Climate: California’s warm, dry climate, particularly in the San Joaquin Valley, is ideal for grape cultivation. Controlled irrigation ensures the vines get just enough water to thrive without diluting sugar concentration in the berries, enhancing sweetness.
  • Pruning and Canopy Management: Growers use precise pruning techniques to limit yield, concentrating sugars in fewer clusters. Canopy management (controlling leaf cover) maximizes sunlight exposure, boosting photosynthesis and sugar accumulation.
  • Soil and Fertilization: Nutrient management, particularly potassium and nitrogen applications, supports vine health and berry quality. Well-drained soils in key growing regions reduce disease risk, contributing to resilience.
  • Gibberellic Acid Application: Since the mid-20th century, growers have used gibberellic acid, a plant hormone, to increase berry size and improve uniformity. This treatment also enhances sweetness by allowing berries to stay on the vine longer, accumulating more sugars.
  • Pest and Disease Management: Integrated pest management and fungicides protect vines from threats like powdery mildew, ensuring healthy, resilient plants that can produce high-quality fruit.

Genetic and Environmental Balance

  • Genetic Foundation: The seedless trait is a natural mutation, but sweetness and resilience are enhanced by the grape’s genetic predisposition to high sugar accumulation and the careful selection of robust vines.
  • Environmental Optimization: California’s long growing season, with warm days and cool nights, promotes sugar development while maintaining acidity, creating a balanced, sweet flavor profile.

Cultural and Economic Impact

  • Adaptation for Raisins: Thompson Seedless grapes became the backbone of California’s raisin industry because their high sugar content and thin skins make them ideal for drying. The drying process further concentrates sugars, enhancing perceived sweetness.
  • Market-Driven Selection: Consumer demand for sweet, seedless table grapes drove growers to prioritize traits like flavor and shelf life, further refining cultivation techniques.

In summary, Thompson Seedless grapes became sweet and resilient through a combination of natural genetic traits (seedlessness, sugar accumulation), selective propagation by growers like William Thompson, and advanced viticultural practices like grafting, irrigation, and hormone treatments. These efforts, paired with California’s ideal growing conditions, transformed a humble ancient variety into one of the world’s most popular grapes for table use, raisins, and wine.

Econ 101: Interest Rates –Another Go

A month ago I reviewed the role of the Federal Reserve’s policy interest rate: https://wcoats.blog/2025/07/17/the-feds-policy-interest-rate/   The subject is so important and seemingly misunderstand by many that I am reviewing it again here.

Interest rates balance the supply and demand for financial assets. Households and firms that save some of their incomes demand financial assets. Households and firms that borrow to invest in productive capital or for whatever reason supply those assets (mortgages, bonds, etc.). Rates on longer term assets reflect the expected value of the short-term rates over that period. Thus the interest rate on a ten year bond reflects the expected value of one year bills over the ten year period plus a small risk premium because the string of short term loans are an alternative to the single fixed rate ten year loan.

The policy interest rate of the Federal Reserve is set by the Fed to pursue its objective of stable money (defined by the Fed as 2% inflation) and high employment (the Fed’s dual mandate imposed by Congress).

This note reviews the Fed’s policy rate. Since 2008 the Fed’s policy rate has been the rate it pays banks for the money they keep on deposit with a Federal Reserve Bank (of which there are twelve but that is unimportant for understanding the role of the policy rate), which on Aug 6 amounted to $3,332 billion. This rate is known as the Interest on Reserve Balances (IORB).

If the IORB matches comparable market rates for equally liquid funds (the so-called neutral rate), banks will maintain their existing Fed deposits. If it is set above that level, banks will have a financial incentive to place more money with the Fed, i.e. lend less in the market, thus creating fewer deposits and reducing the money supply. If the IORB is set lower than the neutral rate, banks will draw down their Fed deposits to lend more in the market thus increasing deposits and the money supply.

The IORB is currently (Aug 6) 4.5%, where it has remained since Dec 2024. At this rate broad money (M2=bank demand, time and savings deposits) has grown between 4% and 5% (from a year earlier) over the last three months. Given that inflation remains above the Fed’s target of 2% it would not seem wise to lower the policy rate and increase the rate of monetary growth especially as higher tariffs go into effect.

To repeat from earlier blogs (because it is so important), if markets anticipate higher inflation in the future (next few years), market interest rates on longer term debt will increase to preserve their real (inflation adjusted) value. Lowering the Fed’s policy rate prematurely would increase the market’s anticipation of higher inflation rates in the future. In other word, lowering the IORB now is likely to increase interest rates on longer term debt. Leave the Fed alone to do its job as best it can.