Central In Name Only (CINO?)

There is far too much shorthand in the study of the economy and markets. We take so many things for granted, we never really stop to ask if its appropriate that we should. The desire for quick rules of thumb is understandable enough given a complex world. There is probably nothing more in it than the economy and markets.

It starts often with ceteris paribus. For academics, the concept is crucial. In the real world, hardly ever is all else equal.

If you are a business that produces widgets, as a stylized example, and the input costs of manufacturing them goes up, all else equal it seems you’re going to have a hard time making money making widgets. It may, in fact, lead you to produce less of them as noted a few days ago in what economists call cost-push inflation.

But in a real economy there are a bevy of choices available even to the most restrictive of scenarios; all else is never equal. Faced with rising input costs, a business could respond to lower profit margins by producing more volume at the same price. This assumes that it can find a way to sell more widgets, but that’s not as unrealistic as it sounds in certain industries.

One of those that immediately springs to mind is the banking industry. There aren’t as many tangible factors preventing volume from being so scalable. When the output, or widget, is loans and lending, achieving such efficiency might even be quite easy.

We are told by every Economics textbook that when the Federal Reserve or whatever other central bank raises interest rates it amounts to economic tightening. Not only that, we are supposed to believe that it is tightening because it restricts, somehow, the money supply. This is the shorthand version rarely ever examined. In practice, there are a whole bunch of things that have to happen before that’s true.

For one, banks might respond to what is nothing more than an increase in their input costs (funding) by increasing volume. You can grow profits via price (steep yield curve, in theory) or volume. If the Fed pushed up funding costs even to a substantial degree, you could overcome them by selling your brains out at relatively the same price (loan interest rate). The yield curve could flatten but you still make out handsomely and the monetary policy is left perplexed.