Central banks have a role to play in our economy, but too often they are in their own bubble of beliefs and blinded by reality. Most central banks have a dual mandate, to maintain a reasonable level of inflation and a reasonable level of employment. They also have to deal with exchange rates. This is confusing, because at times these objectives go in separate directions. The main (but not only) tool central bankers use to achieve their goals is an overnight interbank lending rate that in the US is called the Federal Funds Rate. Changes in the discount rate set expectations in the rest of the bond market’s yield curve and affect everything from commodity prices to stocks to various exotic strategies. As we will see, this is a very blunt instrument that often backfires.

Because the worldwide economy is a complex adaptive system, central bankers generally don’t understand how the levers and gears of the economy work. This causes them to push the wrong ones back and forth unnecessarily. First, we’ll look at the problem of interest rate setting, then we’ll look at the big picture.

Problem: 95 Percent of Trading is Intraday

When the FED changes the discount rate, that affects most rates along the yield curve, all the way out to thirty-year mortgages. It’s not so much the actual rate change but the signal from the FED that they are trying to loosen or tighten the money supply. That sets off a wave of reactions in the markets. The FED doesn’t change rates often, so when it does, there’s usually a big knock-on effect.

But the FED may not realize that 95 percent of trading, both in currency and stock markets, takes place intra-day. That’s right: 95 percent of trading isn’t affected by the discount rate, at least not directly. In fact, there is an effect, and it’s one central bankers may not have understood.

Problem: The Intraday Reaction

If a currency is weak, central banks increase interest rates to encourage foreigners to buy. We don’t see this as much with the major currencies, but it’s common when inflation is high (examples: Argentina, Mexico, Madagascar). Unfortunately, increasing the overnight interest rate has the same effect as we saw in the Intraday Interest chapter — it causes even more intraday shorting. Decreasing the rate causes less intraday shorting. This is because traders can borrow for free and short a high-yielding currency, while buying the currency incurs more risk. This wouldn’t be a problem, except for the fact that 95 percent of all trading is intra-day.

Central bankers aren’t aware of these effects. The tools they use are very blunt. They go for months not saying anything, then they suddenly raise rates by 1/4 of a point, and it causes turmoil and uncertainty in the markets. This is magnified by various financial crises that build up and then fail catastrophically. The central bank under assault will be forced as a measure of last resort to increase the one-day interest rate, which in turn is a harsh break on the economy. Typically, when a central bank hikes interest rates, the price of its currency plummets. Because more than ninety percent of trading is intra-day, and because traders pay no intra-day interest, the central bank action provides an added incentive for the intra-day traders to short the currency. This is like flying a plane with inverted steering — trying to go up causes the nose to dive, and vice versa. So initially, the action of increasing the interest rate will actually make things worse, and the currency will drop even faster. Central bankers who don’t understand what’s going on will then raise interest rates even more, causing an overshoot and a stalled economy. We have seen this happen many times — when a country far from Wall Street has a currency crisis, New York traders are able to make a good intra-day profit while paying no interest at all. Then they go home to their families and watch TV news, where they see people far away who aren’t able to pay their rent or buy groceries.

Solution: Shorter-Term Interest-Rate Adjustments

If the yield curve starts with the one-second interest rate, a central bank can increase rates as small as for one second. This gives bankers a wider range of options to work with. Rather than adjusting (or not) on a quarterly basis, they could go to weekly or daily adjustments, and make changes to much shorter-term rates than just overnight.

Because markets are complex dynamic systems, it makes sense for central bankers to have sharper tools. The one-second interest rate is a factor of 86,400 (number of seconds per day) away from the daily interest rates, thus there is a lot of time for the change to seek a new equilibrium level. An intra-day yield curve puts everyone on a level playing field, stripping out the reverse effect. A continuous process creates smoother market transitions.

Problem: Central Bankers Are Torn Between Adjusting for Inflation vs Unemployment

At the macro level, central bankers try to steer the economy using a small number of very heavy tools, sometimes to achieve conflicting results. This is the equivalent of driving down the street by bumping into the gutters, back and forth, overshooting the centerline each time. There is good evidence, for example, that the US banking crisis of 2008/9 was turned into a worldwide financial crisis by central bankers who didn’t understand they were in a tight-money situation and needed to loosen aggressively. This is the problem with human judgment — it’s often too difficult to get people in a room to agree on a complex topic. If they had algorithmically applied the right tools at the right time, we could have avoided years of worldwide slowdown and unemployment.

Solution: NGDP Level Targeting Using Prediction Markets and Algorithms

Just as we can give central bankers a more accurate instrument in the one-second interest rate, we can also give them a better target to steer by: NGDP. By changing from inflation vs unemployment to nominal GDP, central banks can manage both targets simultaneously, and in the appropriate proportion, which changes according to the situation. The magic of this is that central bankers only have to watch one number and can forget about conflicting directives.

It turns out, we can do even better than asking the open-market committee to watch NGDP. We can make the adjustments algorithmically, using a prediction market and level targeting. This has the effect of driving straight down the middle of the road, making small continuous adjustments to stay centered at all times. You can learn more about this from Scott Sumner, who has a paper and a talk about it. Once we have this in place, the prediction market will give a good signal of where NGDP is likely to be six months later, and we can set monetary policy simply by automating the response to this single signal. Central banks can use intra-day interest rates to keep fine tuning and getting feedback from the markets. In this future, the committee has much less to do, no one has to guess what’s coming, and incremental adjustments make it easy to stay on course.

Decentral Banking

We end this section with a short vision of where world currencies could go. We believe in the decentralized revolution — the power of many people acting in real time to solve problems using technology and mesh networks. Blockchain technology has the potential to revolutionize many industries, and central banking is one of them. It’s entirely possible that in just one generation we’ll see most fiat currencies go fully digital, and many could use something like today’s blockchains. In this future, money supply and interest rates are set not by committees and institutions but by markets and algorithms making small, continuous adjustments. We hope the principles we have presented here provide the basis for a new approach to the world financial system. If you find it inspiring, we hope you’ll join us to help us build this new infrastructure and continually improve it.