Contra Garett Jones: Interest Rates are NOT an Instrument
By David Henderson
Garett Jones argues that the growth rate of the money supply is a target–and targets are often hard to hit, while short-term interest rates are an instrument. He writes:
This is known as the “instruments versus targets” distinction in macroeconomics, and it pays to make the distinction clear. One reason John Taylor’s rule for setting short-term interest rates swept the field of macroeconomics is because it told central bankers exactly what to do with the instruments that central bankers actually use and understand. Taylor didn’t say “do good things, don’t do bad things,” he said, “If inflation falls 1% cut the short term rate by 1.5%”. Practical advice, not a noble goal.
Garett is right that the growth of the money supply is a target and not an instrument. But he’s wrong in claiming that short-term interest rates are an instrument. They are not. They too are just a target.
Consider the three actual instruments the Federal Reserve has for conducting monetary policy:
1. Setting the discount rate, that is, the interest rate at which the Fed lends to member banks.
2. Changing reserve requirements.
3. Buying and selling bonds with federal open market purchases and sales.
#1 is rarely used. #2 is even more rarely used and most monetary scholars and the Fed officials themselves regard it as too blunt an instrument.
That leaves #3. This is the one the Fed uses most. But the Fed doesn’t set interest rates. They try to affect interest rates. Moreover, their target interest rate–yes, target–is the Fed funds rate. The Fed funds rate is the rate at which banks lend money to each other overnight. A bank will typically borrow overnight when it would otherwise have too few reserves to meet reserve requirements. How involved is the Fed in the Fed funds market? Ironically, given the name, not involved at all. The Fed neither borrows nor lends in that market. Instead, the Fed tries to affect overall liquidity by buying or selling bonds, and hopes that this affects the Fed funds rate.
In short, the Fed has a target–the Fed funds rate. That rate is not an instrument. The relevant instrument is open-market purchases and sales of bonds.