Mea Culpa on Fed and Interest Rates
By David Henderson
In my recent post on George Elgin’s primer on monetary policy, I wrote:
Maybe not surprisingly, what I will excerpt here makes the point that Jeff Hummel and I have been making for some time: the Fed does not set or control interest rates.
A commenter named ThaomasH wrote:
The Fed DOES control ST interest rates to the degree they wish if they wish determinedly enough to buy and sell ST assets to achieve their wish.
There is in fact, much doubt.
But my monetary guru whom I mentioned above, Jeff Hummel, writes to tell me that I overstated the case. It’s not that the Fed does control short-term interest rates, and so I was right about that. It’s that the Fed can, by singling out a particular set of assets and buying enough of them, drive down the interest rate on those assets, which is what ThaomasH was saying.
not only can the Fed in theory buy so many Treasuries that it segments that market and pegs those interest rates, but in fact it did so during World War II.
I questioned Jeff further and he wrote:
It was during the war itself that the Fed bought almost all T-bills, keeping their interest rate at 0.375 percent, and bought enough Treasury bonds to keep them at 2.5 percent. And this was a time of inflation, albeit suppressed by price controls.
He also added:
To the extent that the Fed effectively segments the market, the stronger its impact on the specific interest rates it is targeting but then the weaker is its small impact on market interest rates overall. Also, I don’t know off the top of my head how far the Fed’s WWII pegs were from market rates at the time, given the price controls that might have significantly affected inflationary expectations. But in the summer of 1947, the Fed eliminated the peg on T-bills, so only that on Treasury bonds remained until the  Accord [between the Treasury and the Fed]. Here is nice short article on the topic.
Barry Eichengreen and Peter Garber have a long paper on the operation of the peg between the end of WWII and the adoption of the Accord: