Influence, target, control
By Scott Sumner
I often get commenters complaining that the Fed should not be controlling interest rates. They think the market should set rates. In one sense I agree, but in another sense I wonder if the commenters are confused. I wonder if people think the Fed moves interest rates away from the market equilibrium. It does not, it influences the market equilibrium. Let’s start with an analogy from the oil industry, and while doing so I want you to think about how inadequate the English language is in this area.
Consider two cases:
1. President Carter introduces price controls on oil, setting a price ceiling at $25/barrel, even as the market price in $34/barrel. A shortage results, with long gas lines.
2. The Saudi oil company Aramco adjusts oil production to keep market prices at $36/barrel. There is no shortage, no gas lines.
In ordinary English, these are two ways that governments could be said to “control” prices. But I think you’ll agree that they are vastly different methods, and have vastly different implications for the economy. The term ‘control’ is being used in two very different ways.
I hope it’s obvious that the Fed’s control over interest rates is like the Aramco case, not the price ceiling case. There are at least three different senses in which the Fed could be said to control interest rates:
1. The Fed might fix interest rates, via usury laws.
2. The Fed might target interest rates (as the Fed actually does.)
3. The Fed might target some other variable like the money supply or exchange rates, and yet nonetheless Fed actions indirectly determine the level of interest rates.
Or I suppose the Fed could be abolished. But as long as the Fed exists, the meaning of the term ‘control’ is more ambiguous than you might think. Consider 3 policy options:
1. The Fed has a 2% inflation target, and sets a new fed funds targets every 6 weeks, adjusting rates as needed to target inflation. In that case is the Fed controlling inflation, interest rates, or both?
2. The Fed has a 2% inflation target, and sets a new fed funds targets every single day, adjusting them as needed to target inflation. In that case is the Fed controlling inflation, interest rates, or both?
3. The Fed has a 2% inflation target, and has no fed funds target. Instead it targets the TIPS spread, or a CPI futures contract. In that case is the Fed controlling inflation, interest rates, or both?
Case one and two are pretty similar, as we’ve merely shortened the time between meetings from 6 weeks to 1 day. And yet arguably cases #2 and #3 are much more similar to each other, than to case #1. That’s because in both case #2 and #3, the interest rate changes each day, in a way that the Fed believes will stabilize expected inflation over time. The interest rate path is quite similar in those two cases.
Here’s the problem. Fed policy affects all nominal variables, including nominal interest rates, nominal exchange rates, nominal GDP, the nominal prices of apples, oranges and Brazilian hot wax treatments. All nominal variables. In the 1970s, the Fed printed lots of money, causing almost all nominal variables to be higher than they would have otherwise been. But we usually don’t think of the Fed as “controlling” those prices, for two unrelated reasons. One reason is that the Fed’s actions don’t impact real variables, in the long run. The other reason is that the Fed was not targeting most of those variables. Does it matter if they were? Not as much as you might think.
Consider two policies: In one case the Fed continually adjusts the target fed funds rate in order to keep expected inflation at 2%. In the other case the Fed continually adjusts the target nominal price of zinc, in order to keep expected inflation at 2%. If the Fed does its job in a competent way, then the path of zinc prices would be identical under either regime. Does it then make sense to talk about the Fed “controlling” zinc prices in one case but not another?
Yesterday I did a post criticizing Mike Konczal on the distinction between the Fed acting and not acting. Let me provide a better analogy over here, as some missed the point. It might make sense to distinguish between an “activist ship engine” that is fed lots of fuel and an idle engine. But the steering wheel of a ship is different. There is no single setting of the steering wheel that is more active than another. It doesn’t require any more fuel to set steering at NNE than at NNW.
By analogy, it makes sense to talk about using fiscal policy, as the natural benchmark is a fiscal policy set on classical cost/benefit considerations, and the alternative is a deficit that would not otherwise occur, used to boost GDP in a recession. Deficits require costly future taxes with deadweight losses. In contrast, it’s nonsensical to talk about “using monetary policy” unless your alternative is pure barter. There is no benchmark of not using monetary policy; rather there are merely different settings of various monetary indicators. (Even with no Fed, the private money issuers would have some sort of “policy”.) If the Fed would like to see NGDP growth at X%, and a certain policy setting would achieve that, then any failure to achieve X% growth can be said to be “caused” by the Fed.
Konczal talked about a housing crisis causing a drop in AD, and the Fed not responding. But there is no evidence that that’s what happened. If, after July 2007, the Fed had kept the monetary base growing at exactly the same rate as in the 5 previous years, there might well have been no recession. Or there might have been a Great Depression. (In my view there would have been no recession in 2008, but major problems later, but we can’t ever know.) So it’s meaningless to talk about a housing crash causing a drop in AD in 2008, without knowing the Fed’s policy regime.
The Fed meets every 6 week to set policy. The only question is whether they set the right or wrong policy. They have no ability to “do nothing”; it’s a meaningless concept for monetary policy.
PS. I just got this email from the Hypermind prediction market:
Suite à la fermeture d’un concours sur Hypermind, votre compte de gains en Euro a été crédité de 10€
It’s one of those good news/bad news situations. The good news is that I’m 10 euros richer. The bad news is that my ability to beat the market undercuts my belief in the EMH. Should I hope that I was right or wrong about the EMH?
(I shorted the one year NGDP contract early in 2015, when it was trading around 4.2%. NGDP growth ended up being 2.9%)