I was very pleasantly surprised to see this news headline:
The Fed Doesn’t Have the Control Over Interest Rates Everyone Thinks It Does
Here’s the subhead:
Data suggests the Fed is more of a follower and less of a leader when it comes to interest rates.
Can this lack of control actually be shown by “data”? I’d say you need data and theory, in combination. The concluding paragraph hints at the mechanism:
Further, when you invert the test to see if shifts in Tbill rates are what precipitate a move for the Fed, it’s actually more likely the fed funds rate will change based on what the Tbill rate did in the former period. It’s not incontrovertible evidence, but over the span of nearly 60 years, this does not suggest the Fed is the dictator of rates it’s believed to be.
So if bonds are largely deriving their prices independent of central body control, what’s driving them? Basic macroeconomics.
Yes, but this needs to be fleshed out a bit.
Imagine you are hiking along a linear mountain ridge. The top of the ridge is rounded, but the terrain slopes off on either side, getting steeper and steeper the further off track one gets. Now let’s think about the sense in which you control the direction of your steps, and the sense you do not.
Over a long period of time, you must follow the path of the mountain ridge, or else you’d fall to your death. But over shorter periods, you can get away with walking a few paces off track, one direction or another.
The Fed is sort of like that. On a day to day basis, it has the ability to raise or lower interest rates without there being an economic catastrophe. But over longer periods of time, they need to follow the market unless they are willing to allow the economy to slide into a deep depression or hyperinflation. Thus over longer periods of time, it’s not unreasonable to view the “basic macroeconomic” forces as determining the path of interest rates.
Jason Orestes (who wrote the article) is correct that the market can predict Fed rate decisions, to some degree. How could this be the case? The most likely explanation is that the markets forecast the basic macroeconomic conditions, and then estimate how the Fed would need to react to those shocks in order to keep aggregate demand growing at an acceptable rate.
How would things be different if a “God-like” figure ran the Fed? Here I will define God-like as omnibenevolent and omniscient, but not omnipotent. If you are not religious, substitute a future super smart AI that is programmed to maximize social welfare by minimizing deviations from a specific monetary policy target, and who also has access to all of the online data in the world that pertains to the economy.
The “ridge” that this omniscient Fed chair walks along is no longer gently rounded; it’s a knife edge, with death looming if there is a slight deviation from the optimal path in either direction. (Here “death” is a metaphor for failure to be omnibenevolent.) If we assume the pre-2008 policy regime, where the Fed basically relied on only one tool (changes in the monetary base), then the perfect Fed chair has no control over interest rates. Each day they set the monetary base at the level that best maximizes social welfare, and the market determines the interest rate.
In the real world, central bankers are not omniscient. Rather they are somewhat incompetent. I don’t mean that as a pejorative, rather merely that they are not perfect. The greater the degree of incompetence, the more control they have over interest rates.
Jay Powell has less control over interest rates than Arthur Burns had, precisely because Jay Powell is more competent than Burns. (Or less corrupt, if you prefer that explanation for Burns’ poor record at the Fed.)
PS. This post is slightly less applicable to the post-2008 period, where the Fed has two instruments—changes in the monetary base and changes in interest on reserves. But the basic idea remains approximately true.
PPS. I am taking the Fed’s goals as a given. If they change their goals (say a higher inflation target) then they can obviously change nominal interest rates. But they still have no control over real interest rates.
READER COMMENTS
Thaomas
Feb 8 2020 at 9:34am
I guess.
But what do we make of the hiker who very gradually wanders farther and farther from the path? Or having gotten off the path then starts walking almost parallel to the path? Or stays down to the side of the path because if he starts back up he fears being criticized for risking going too far off the path on the other side? Is he an incompetent path follower?
I don’t think any of these situations are usefully discussed in term of how competently the hiker controls his steps.
Scott Sumner
Feb 8 2020 at 12:52pm
The idea was that they had a small amount of discretion, but not a lot.
The further the distance, the more deterministic the direction.
Thaomas
Feb 8 2020 at 11:58pm
In ten years they had time to get pretty far away from 2% on average inflation.
I just heard the 2017 Larry Summers talk with Tyler and he came down, cautiously, for NGDP targeting [though allowing that PL targeting or just a higher inflation target (to undershoot?) might be OK, too]. Which was great, but then he turned around and talked about the Fed’s mistakes since 2008 in terms of overestimating what the “neutral” interest rate is!!!! And I just wanted to scream “interest rates are and instrument, not a target!”
Mike Sandifer
Feb 9 2020 at 12:48am
Even though interest rates are a symptom and not a cause, it still seems talking about nominal rates versus the neutral rate is a very clear way to talk about the stance of monetary policy. It really eliminates most of the problems that sometimes occur when people merely focus on nominal or real rates.
Thaomas
Feb 10 2020 at 10:36am
I don’t think the fed should target real interest rates, either. The are supposed to target prices and real income (I take it that’s what Congress means by “unemploymet”). In normal circumstances moving ST interest rates is a perfectly unobjectionable way to try to get closer to a target when the economy is not there so long as they are prepared to use other instruments if they run into constraints on ST interest rates and everybody knows that they will keep doing something until the targets are achieved.
I think that PL targeting (for the “prices” half of their mandate) is a less ambiguous and better way of targeting than “symmetric” or average inflation. Zero one quarter and 4% the nest quarter gets you a 2% average but minimizing deviations from a 2% pa trajectory for the PL is better, (assuming that’s the optimal target given the degree of price stickiness or whatever the reason for not targeting zero). What we want is monetary policy to create a little uncertainty about relative prices in the long term as possible. Does anyone care about what inflation this quarter was per se?
Quin
Feb 9 2020 at 8:51am
As a hiker I agree. As a motorcycle trail rider I agree more. For example, a motorcycle trail rider on a ridge is the fed. World economic chaos controls the riders speed on the trail. Slow speeds no chaos in world, the fed can make good decisions without riding off the trail to economic depression. But when global economic chaos speeds up the motorcycle and trail ahead can’t be scanned properly for dangers, the fed can easily crash or fall off the knife blade trail
Brian Donohue
Feb 10 2020 at 10:12am
The Fed raised IOER 5 bps last month. Obvious, if minor, misstep, which raises the simple question: why?
The only thing I can think of is that it makes life easier for bankers.
Thaomas
Feb 10 2020 at 10:40am
They clearly are not yet fully committed to a 2% pa PL target whether their reason is to make bankers happier or not, I don’t know.
Comments are closed.