Only incompetent central bankers control interest rates
By Scott Sumner
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.