What’s the Fed for? What are central banks generally for?
Most of them have multiple functions, but a – if not the – core function is well captured by a key phrase in the US central bank’s – the Fed’s – enabling act: ‘stable prices.’ The Fed and other central banks are meant to maintain stable prices – that is, to prevent serious inflation like that of the 1970s or deflation like that of the 1930s or 2010s.
Notice that ‘stable prices’ says nothing about what prices. There is no limiting language in the Federal Reserve Act to suggest ‘these prices, not those prices.’ The Act just says ‘prices.’
How should we understand this word ‘prices,’ then? Well, let’s think about that… Some prices seem to be more consequential than others, precisely because they feed into many other prices on the economy’s supply side, or because they are prices of critical human necessities – food, water, shelter, for example – on the economy’s demand side.
Consider energy prices. These determine costs of production and delivery of nearly all other goods and services supplied in our economy. Ditto wage rates and salaries. Food prices for their part determine how well nourished we are – even whether we’re nourished at all – while heating oil and housing prices determine whether some people survive the winter. Labor rental prices determine the costs of all things produced or supplied by working people, not to mention the level of effective consumer demand that keeps profits accumulating and workers working.
I call these prices ‘systemically important,’ precisely because their significance reaches beyond the markets in which they are determined. They ‘spill over,’ they generate what economists call ‘externalities.’ Think of them by analogy to the large, interconnected ‘too big to fail’ banks and other financial institutions we call systemically important – the ‘systemically important financial institutions,’ or ‘SIFIs,’ hardened into a regulatory category over a decade ago by Dodd-Frank.
Indeed, remind yourself that some benchmarks and indices – that is, averages of prices commonly used as broad measures of market conditions, like Libor, SOFR, the Consumer Price Index (CPI) or Dow Jones Industrial Average (DJIA) – can also be systemically important in the senses just elaborated, and you’ll see a clear analogy to Dodd-Frank’s systemically important financial institutions: Just as there are SIFIs, so are there SIPIs – systemically important prices and indices.
Why are SIPIs worth bringing up (again) now, especially given that I’ve brought them up often for well over a decade? (E.g., here, here, here, here, here, here, here, here, here, here, and here, among other places.)
The answer is that the systemic importance of certain particular prices is once again salient – indeed a matter of urgent and still-growing public concern. I refer to what financiers call ‘commodities’ – foodstuffs, fuel-stuffs, and certain production-critical metals and minerals. Prices of all these essentials – these SIPIs – have been very volatile of late. Their highs have been very high, their lows very low, and the rate of this vertigo-beckoning fluctuation has been as margin-account-draining as head-spinning.
What’s happening here?
It is important to recognize that while ‘fundamentals’ play obvious roles in determining these prices in the long run, they do not play much role in the short run. There is no fundamental reason that Brent Crude would sell for $100 a barrel today, $140 a barrel tomorrow, and $80 a barrel one week hence, for example. Rather, high frequency fluctuation happens because high-roller speculators with cheap credit in thin markets – more like cliques than like marketplaces – make prices move by betting they’ll move, prophesying outcomes self-fulfillingly.
Of course, fundamentals do provide contexts in which short-term betting behavior can superficially look to be justified. Indeed pretexts are crucial if one is to ‘tell a story’ about her trades and thereby persuade others to follow so that she can then benefit – pyramid-style or in less savory ways. There are many such stories available now – war in the breadbasket known as Ukraine, sanctions on the oil well known as Russia, supply chain disruptions wrought by the plague known as Covid, and moves on the rare earth metals crucial to green industry by the geopolitical rivals known as the US and China.
These are important true stories. But they are never the whole story. Indeed they are hardly even the relevant story.
Some readers will remember when oil prices reached new record highs in the spring and summer of ’08. Some folk blamed tensions, then war, between Russia and Georgia. Others observed that the world had reached ‘peak oil’ – there were no more discoveries to be made and hence prices would now rise without ceasing forever. Counterpart remarks had been made to explain record housing price rises in the decade or so before 2006 – Ricardian marginal lands theory combined with Malthusian population theory to ‘prove’ prices ‘could only go up.’
At present we’re witnessing dramatically destabilizing price volatility in multiple commodity markets – maybe more at one time than we have ever seen before. And the chaos is hardly confined to just one or a few countries – it’s worldwide. Wheat and other grain prices are spiking and plunging and spiking and plunging everywhere. Oil prices are doing likewise. So too, though somewhat less visibly, are prices of metals and minerals now vital to new green industries growing in China and Europe and even States’ side. In all of these cases long stories can be told – the stories I hinted at several paragraphs back.
But again, these are backstories, not the stories. The stories are speculative trades done with QE-enabled cheap borrowings and privileged information – the kind of information enjoyed by well-connected traders on thin markets – markets that function in large part as clubs rather than circuit-boards. Add endogenous credit-money of the QE variety to these places, and you get recursive collective action problems out the proverbial wazoo – you get ‘vicious circle’ volatility with respect to prices that neither we, nor, increasingly, even lesser traders can afford to watch gyrate or stagger.
Why is this publicly problematic, and again what’s the Fed – and other central banks worldwide – got to do with it? It’s publicly problematic because all these prices are, in the idiom introduced just above, SIPIs. They are systematically important in the senses I rehearsed earlier. And what the Fed and other central banks have to do with it is that only they, preferably in collaboration, can collar these multiple now globally restive SIPIs.
Wheat and other grain prices both are prices of essential comestibles and inputs to other prices. Their rising causes calories’ falling – people are poised to go hungry this year. Petroleum prices of course affect both production and transportation – including transportation of consumer goods – ubiquitously, as we’ve not yet transitioned to green. Meanwhile metals and minerals prices slow that transition itself, by making it much more expensive, if not impossible, for as long as they’re driven up artificially – that is, speculatively.
Here’s where the Fed comes in. And not just the Fed. Central banks worldwide…
When a price fluctuates wildly in the short-term, when long-term ‘fundamental’ value is simply a mean toward which prices tend over time but from which they depart quite dramatically up and down day to day, there is reason to ‘collar’ them close to that mean – at least if the prices are SIPIs and market failures are readily seen to be why they are short-term volatile. And there’s no better collarer than the central bank. Its information-gathering and -aggregating capacities, its balance sheet and its literally infinite liquidity within its jurisdiction enable it and only it to ride out the liquidity crunches that attend bipolar speculative thrill-rides in commodity markets.
What do I mean here, specifically? I mean this: the Fed and other central banks must collaboratively begin designating certain prices and indices ‘systemically important,’ using criteria analogous to those that Dodd-Frank does in designating SIFIs. They must then undertake to counter-speculate against the speculators who drive SIPIs fleetingly above and below their longer-term mean values, shorting them when speculators are over-long, going long when speculators are over-shorting. The object must be to keep these prices nearer their long-term means, any time peak-to-tough amplitudes can’t be explained by reference to fundamentals but can be by reference to dramatically asymmetric information, market power, and very cheap credit.
Maybe this sounds ‘radical’ or unfamiliar to you, a revolutionary departure from precedent. It shouldn’t, and it isn’t.
The reasons to collar all SIPIs are obvious, and ditto the capacity. For remember, the idea is premised on the proposition – hardly controversial at this point – that short-term price fluctuations are speculative epiphenomena, not fundamentals-based ‘real’ phenomena. All that a central bank or coalition of such needs, then, are (a) sufficient informational capacity to differentiate fundamental bases from credit-fueled speculative bases for price movements (the better the information, hence precise the differentiation, the tighter the collar – and vice versa); and (b) either greater price-moving power (‘market power’) or greater staying power (liquidity) than private sector speculators. Does anyone doubt that the Fed, let alone if collaborating with its peers worldwide, has what it takes to maintain price stability even in this uncovered market?
If not, that might be in part because, again, the proposal here isn’t all that radical, at least not in principle. We have long been doing the functional equivalent. Consider two familiar examples …
One global market with club-reminiscent properties and potential manipulation vulnerabilities much like those of commodity markets is the foreign exchange market. Few traders, asymmetric information, lots of cheap QE-money to gamble with, etc. Central banks understand this, while also understanding that wildly fluctuating currency values are profoundly destabilizing – the kind of craziness that gets you trade breakdown and World War II. So the world’s central banks, Fed included, manage what they call a ‘dirty float’ regime, ‘intervening’ in the markets for the currencies they themselves issue to ‘manage’ fluctuations within reasonable bounds – that is, collars. Swap lines introduced since the ’08 crash further enhance the arrangement. Nobody thinks this ‘radical’ – not anymore.
One more example… Every weekday morning, women and men at a Lower Manhattan trading desk read sets of instructions composed for them the night or early morning before. These instructions have been developed on the basis of reams of market and trading information digested in the previous hours, with a view to determining what the demand for money is apt to be in the coming hours. As the sun rises over the East River, these traders will begin trading, and will be trading all day. And they’ll be doing it for the US.
For I am describing the New York Fed trading desk, whose personnel are executing instructions attributable to the Federal Open Market Committee (FOMC), which oversees Fed open market operations in Treasurys and Treasury repo. The Fed does this to collar another systemically important price bearing on broad price stability – the money rental, a.k.a. ‘interest’ rate. That’s right – ‘stable prices’ per the Federal Reserve Act are collared prices, collared because they are, whether generally articulated in this manner or described less pellucidly, SIPIs.
But how to collar commodity prices, you ask? Easy: What New York is to money prices, Chicago is to commodity prices. The Chicago Mercantile Exchange (CME) on and near Wacker is to commodities and their derivatives much what the New York Stock Exchange and Big 6 banks are to money and securities on and near Wall Street. And lo, as I discussed here in January, the Chicago Fed now has a new trading facility virtually identical to – indeed set up in part by personnel from – the New York Fed’s trading unit.
Has this new facility gone up because the Fed agrees with me here? Well, maybe, seeing as how I pushed this idea incessantly while working there over a decade ago. But I doubt it. I suspect that the Fed’s figured this out on its own, for it’s really quite obvious once you think about it. And legal as well. The Fed and its peers worldwide will be collaring commodities. If not by this year, then next.
For they must. And they know it.