The Fed doesn't have a magic wand
Suppose I put a digital sign outside my house, with “Sumner’s fed funds rate target” and a number. And suppose I adjusted the target rate from 0.25% to 0.5% last week, right at 2pm on Wednesday. Would I have caused the fed funds rate to increase? Obviously not. So why do people assume the Fed controls market interest rates?
The Fed has tools that I don’t have, which allow it to influence market interest rates. They can adjust the size of the monetary base, or they can influence the demand for base money. The latter can be done via changes in interest on reserves or changes in reserve requirements. But prior to October 2008 IOR did not exist, and the Fed found reserve requirements to be too clumsy to use as an effective policy tool. That simplified things, as it means that prior to October 2008, the only way that the Fed could directly influence market interest rates was by adjusting the supply of base money.
One way we know this to be true is that the Fed asked for permission to adopt IOR precisely because in October 2008 they wished to target interest rates at a level that would have required a much smaller monetary base than they preferred. (They had recently injected lots of base money to relieve illiquidity in the banking system.) So obviously the Fed does not have complete control over interest rates—other forces will move them around even if the Fed is not doing anything to the monetary base.
Now here’s where people get confused. Because the Fed can influence rates, they assume that any movement in rates is caused by the Fed, as if it had a magic wand. I suppose there is a sense in which that is true, as there is always some counterfactual policy that would have produced a different path of interest rates. But it’s not true in the sense that people assume. Here’s a recent comment I got:
My brain has a hard time getting past the point that the Fed lowered rates, to try to make more money available for spending, to try to increase prices and NGDP, averting deflation, which sounds like a sensible policy.
This has things backwards. The Fed doesn’t lower rates to make more money available, they (sometimes) make more money available to lower rates. But at other times rates fall because of market forces, as there is no increase in the amount of money in circulation. Here are the monetary base and interest rates on August 1, 2007:
MB = $855.960 billion, fed funds rate = 5.25%
And here is the same data on April 9, 2008:
MB = $855.411 billion, fed funds rate = 2.25%
Why did interest rates fall sharply? Perhaps one is entitled to say the Fed caused rates to fall, in the very limited sense that some counterfactual policy would have produced a different path for interest rates. But one is not entitled to also call that an expansionary monetary policy, even though expansionary monetary policies do in fact sometimes cause interest rates to fall.
This last point is something people really have trouble wrapping their minds around. The Fed policy of late 2007 and early 2008 did not inject new money into the economy. By itself that means little, as the monetary base is also not a good indicator of the stance of monetary policy. But when the base is stable and interest rates fall sharply, it is quite likely that monetary policy has become much tighter. If you prefer the Equation of Exchange, then M is not always a good indicator of changes in M*V. But when M is stable, and interest rates fall, then both V and M*V are likely to fall.
And when both the base and the level of interest rates fall sharply, then look out below.
PS. Here’s some data from October 1929 to October 1930:
October 1929: MB = $7.345 billion, Discount rate = 6.00%
October 1930: MB = $6.817 billion, Discount rate = 2.50%
Yikes! Falling interest rates combined with a falling monetary base is a recipe for disaster. Less supply of base money and more demand for base money. The value of base money rises sharply. The Great Deflation.
And yet some economists will say “The economy failed to revive on the Fed’s rate cuts of 1930.” My response: