The Fed Doesn’t Actually “Control” Short Term Interest Rates

At least not in the sense that NYC controls the rent on apartments.  This post was triggered by a recent Karl Smith post:

The interest rate on T-Bills is simply whatever the Fed wants it to be. T-Bills and bank excess bank reserves are essentially interchangeable. In normal times the value of excess reserves is the Fed Funds rate. Today it is the Interest on Reserves rate. However, both of those are essentially controlled by the Federal Reserve.

This is the conventional wisdom, but I thinks it’s (approximately) wrong.  Because this is very confusing, let’s start off by discussing why controlling interest rates is not like controlling rents.  Under rent control, the government legally mandates a particular maximum rent, and a shortage often results.  The Fed doesn’t put any legal price controls on fed funds or T-bills.   There is no shortage.  Rather it adjusts the money supply as needed to keep short term rates at the desired level.  One might argue that this is merely a quibble, but in fact there is a much bigger problem with Karl’s argument, which he alludes to in this paragraph:

While its possible that the interest rate on T-Bills averages only 3.3% over the next 30 years this is – hopefully – extremely unlikely. It implies that nominal GDP growth will average 3.3% over the next 30 years, as the Fed must ultimately align interest rates with nominal growth rates or the economy will persistently overheat or stagnate.

To see why this matters, consider the following thought experiment.  Suppose the Fed was run by God, and God was considering the following options for hitting a 2% inflation target:

1. Adjust the monetary base until God himself (or herself) expects 2% inflation.
2. Adjust the monetary base until the fed funds rate settles at a level that God expects to produce 2% inflation.
3. Adjust the monetary base until the euro/$ exchange rate settles at a level that God expects to produce 2% inflation.
4. Adjust the monetary base until the CPI futures market settles at a level that God expects to produce 2% inflation.  This need not be 2% inflation in the CPI futures market, because God knows the exact risk premium in CPI futures prices.  (And I mean “God knows” literally, not in the sense of “who knows?”)

I hope it’s obvious that all 4 monetary regimes are identical.  The path of base money, fed funds, exchange rates and CPI futures prices is exactly the same in all four cases.  I think it’s also obvious that no one would call options 1, 3 and 4 “controlling interest rates.”  Since option 2 is exactly the same, it is also not “controlling interest rates.”

So what is different about our current monetary regime that leads people to think that the Fed does “control” short term interest rates?  I guess we could start with the fact that Ben Bernanke isn’t God.  But seriously, I see two differences.  I foresaw God adjusting the fed funds target continuously, and the Fed actually adjusts the target every 6 weeks.  And I saw God as being omniscient, and the Fed . . .  well let’s just say it’s not.  So obviously there is a sense in which Karl is right.  The Fed sort of “controls” (but doesn’t legally fix) the fed funds rate for 6 week periods.

But the Smith quotation on top referred to T-bill yields, not the fed funds rate.  In this case Karl’s argument is even weaker.  As the market sees the economy strengthen and/or inflation rise, it will bid up T-bill yields in anticipation of the Fed raising the fed funds target at the next meeting.  If the market sees the central bank as operating on a target-the-forecast basis, then T-bill yields will always be determined by the market, not the Fed.  They will represent the market’s estimate of what sort of short term interest rate path would mostly likely be associated with 2% inflation (or 5% NGDP growth, if that were the Fed’s target.)

Looking at monetary policy in terms of interest rate control is likely to lead one astray:

1. It leads many people to equate low rates with easy money, and vice versa.  (Never reason from a price change.)  Karl doesn’t do that, but lots of people do.
2. It leads lots of libertarians to assume the Fed is more interventionist that than it really is.  The Fed does have monopoly on money creation, and that’s obviously very interventionist.  It means the Fed steers the nominal economy (although like all captains, it occasionally goes off course.)  But it doesn’t make sense to argue the Fed targets inflation and is also highly interventionist in the credit markets.  If T-bill yields are X% when the Fed is successfully targeting inflation at 2%, then those are essentially free market short term interest rates.  You can’t target two variables with one tool.  It may be that 2% inflation was a bad target in the middle of the housing boom, and tighter money was desirable.  But it makes no sense to argue the inflation target was wrong and also that the interest rates were too low.  Had the target for inflation been lower, or had a 5% NGDP target was been adopted (as David Beckworth recommended), it’s quite likely that short term rates would have been even lower, as economic growth would have been weaker.  Nominal interest rates are strongly procyclical, they are highly correlated with NGDP relative to trend.

PS.  Although Milton Friedman was a great economist, he made one silly mistake.  He once argued that fixed exchange rates were a bad idea because the market should set exchange rates.  But fixed exchange rates are no more nor less interventionist than a fixed growth rate of the money supply (Friedman’s preferred target.)  In a sense all central bank policy targets are equally interventionist.  If the central bank remains in public hands, the only question is which target produces the least harm to the economy.

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