I recently did an Econlog post trying to explain why it’s misleading to speak of the Fed “controlling” interest rates. I’m not entirely satisfied with that post, so today I’ll make another attempt, from a different angle. I’ll present 5 hypothetical monetary policies, and in each case ask you to consider whether the Fed is controlling interest rates:
1. The FOMC meets every six weeks, and sets an interest rate target to the closest 1/4%. They instruct their NYC desk to do open market operations as needed to keep interest rates close to the target, although modest intraday fluctuations in the fed funds rate are allowed. Each six weeks, the FOMC selects an interest rate target that its research staff believes is most likely to lead to 4% NGDP growth.
2. The FOMC meets every single day, and sets an interest rate target to the closest 0.01%. They instruct their NYC desk to do open market operations as needed at the end of each trading day to keep interest rates close to the target, although modest intraday fluctuations in the fed funds rate are allowed. Each day, the FOMC selects an interest rate target that its research staff believes is most likely to lead to 4% NGDP growth.
3. The FOMC meets every single day, and sets an interest rate target to the closest 0.01%. They instruct their NYC desk to do open market operations as needed at the end of each trading day to keep interest rates close to the target, although modest intraday fluctuations in the fed funds rate are allowed. Each day, the FOMC selects an interest rate target that an omniscient God tells them is most likely to lead to 4% NGDP growth.
4. The FOMC meets every single day, and sets an interest rate target to the closest 0.01%. They instruct their NYC desk to do open market operations as needed at the end of each trading day to keep interest rates close to the target, although modest intraday fluctuations in the fed funds rate are allowed. Each day, the FOMC selects an interest rate target that the NGDP futures market tells them is most likely to lead to 4% NGDP growth.
5. The FOMC meets every single day and instructs their NYC desk to do open market operations as needed at the end of each trading day to maintain NGDP futures market forecasts of 4% NGDP growth.
In which of these 5 cases does the Fed control interest rates? Some might argue that the first four cases involve interest rate control, while the 5th does not. After all, interest rates are not even mentioned in the fifth policy, where there is no explicit attempt to move interest rates to any specific location.
But there’s a problem with this view, as policies #4 and #5 are actually identical, merely described using different language. If you have trouble seeing this, consider the following analogy:
1. I press the ball of my foot hard enough on the sole of my shoe to depress the car’s accelerator pedal hard enough to achieve a speed of 60 mph.
2. I use my foot to depress the car’s accelerator pedal hard enough to achieve a speed of 60 mph.
Do you see that these are two different ways of describing the exact same action? The same is true of monetary policies #4 and #5. One says do enough OMOs to get interest rates to a level where 4% NGDP growth is expected, and one says do enough OMOs to get NGDP expectations up to 4%. So we can’t draw the line there, and will have to draw the line somewhere else.
I’ll cut to the chase. In my view the only useful distinction occurs between #1 and the rest of the options. In case #1, the Fed is controlling interest rates or controlling NGDP expectations, depending on the time frame. Within a 6-week time frame they control interest rates and let NGDP growth expectations fluctuate. Over a longer time frame they are stabilizing NGDP growth expectations and letting market interest rates respond endogenously. In all the other 4 cases, the Fed is simply controlling NGDP expectations and letting interest rates respond endogenously.
So in case #1, interest rates are partly controlled by the Fed and partly endogenous. Because the long run is far more important than the short run, I’d say interest rates are 5% or 10% controlled, and 90% or 95% endogenous in case #1. In the other four cases the Fed does not control interest rates; they are 100% endogenous.
PS. When I read MMT literature I get the impression that they don’t understand these distinctions at all.
READER COMMENTS
Benjamin Cole
Jun 4 2019 at 1:00am
I think I agree with this post….but what are long-term rates? More than 10?
The Bank of Japan targets zero-percent interest on 10-year JGBs, and buys when the rate goes above that. Is this “controlling” long-term interest rates? It seems to work; they seem able to “control” interest rates in this case.
Does the BoJ’s very public declaration that it will buy 10-year JGBs to keep rates at zero create a self-fulfilling “public expectation” of zero-percent rates on 10-year JGBs?
On the short-end of the stick, some say the Fed is keeping rates artificially high. I guess this is because of IOER, reverse repos, and floors and corridors and who knows what all. Some say this Fed action is one contributor to the present inverted yield curve.
I find the best approach is to agree with the last well-written paper I have read.
Thaomas
Jun 4 2019 at 8:36am
I guess this is helpful but it seems better to just harp on (I know it is not easy) the difference between a target: full employment symmetric inflation, inflation ceiling ceiling, NGDP, “financial stability” or whatever and an instrument ST interest rates, foreign exchange purchases, long term domestic asset purchases or whatever the Fed’s models tell it will cause the economy to achieve its target.
John Dutemple
Jun 4 2019 at 8:51am
I routinely see Fed prediction of interest rates vs actual that lead me to believe they 1) have little control over interest rates or 2) are lousy at predicting something they are supposedly in control of. Or both.
Scott Sumner
Jun 4 2019 at 9:37pm
John, That’s right. To the extent that they target inflation or NGDP, they do not control interest rates.
Greg Jaxon
Jun 4 2019 at 1:27pm
Scott, I could not agree more that the terminology and rhetoric applied to FOMC activity uses the word “control” quite loosely. At best these activities are themselves “endogenous” releases of economic forces meant to drive whichever of the five (or five thousand) game plans the monetary powers-that-be ever settle upon.
I note that in each of the five, you’ve left a time window open between the choice of FOMC action and its implementation. #1 sustains the choice over many days but acts at unpredictable times, the rest develop a choice sometime during the day then have one concentrated effect at End-of-Day. I’d like to hear your thoughts on whether this might make front-running a profitable arbitrage.
If you’ve previously written some critique of the make-up of GDP data (either its fundamentals, or mere technical issues), could you link to this? I’d like to believe that NGDP could be a measure of the real economy’s demand for circulation credit, and that options #2 and #3 are identical statements, but I don’t, and I suspect neither do you.
Scott Sumner
Jun 4 2019 at 9:40pm
Greg, I don’t see where there is any ability to arbitrage. Otherwise it would already be being done.
I don’t understand your question about NGDP. It’s the make-up of inflation that I have criticized.
Capt. J Parker
Jun 4 2019 at 5:24pm
I think there is a big assumption here that there is a proportion effect linking interest rates and NGDP. I question that this is the case because I’m inclined to believe that monetary policy can do only one of two things: either A) supply all the liquidity the financial markets demand OR B) provide less liquidity. Doing A allows GDP, real or nominal, to expand, doing B causes a recession. From Macro 101 on, we are asked to take on faith that if NGDP is growing when interest rates are i then NGDP will grow faster if interest rates are .9i and the FED can “fine tune” the path of GDP. But, is there really any evidence for this? Why isn’t the correct analogy something like: it is a fallacy to think your house will warm up faster if you set your thermostat to 90F than it would if you set your thermostat to 75F.
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