David R. Henderson  

Krugman on Interest Rates

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Paul Krugman once bragged--I can't find the link off-hand--that he doesn't read much of what libertarians and conservatives write on economics, but he really knows their views well anyway.

I wonder.

Earlier this month, Jeff Hummel wrote one of the Feature Articles on Econlib, "The Myth of Federal Reserve Control Over Interest Rates." In it, he showed why the Fed has little control over interest rates.

So what does Krugman write today? This:

Think about it: China selling our bonds wouldn't drive up short-term interest rates, which are set by the Fed. It's not clear why it would drive up long-term rates, either, since these mainly reflect expected short-term rates. And even if Chinese sales somehow put a squeeze on longer maturities, the Fed could just engage in more quantitative easing and buy those bonds up.

What's Krugman's basis for his view that the Fed sets short-term interest rates? Or, another way of asking, where does Hummel go wrong?


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CATEGORIES: Monetary Policy



COMMENTS (12 to date)

I certainly need to brush up on my money and banking, but there were a couple of things that struck me.

As I understand it, the Fed aims to enact countercyclical monetary policy, which by nature is short-term. As far as I can tell, New Keynesians aren't under the illusion that the Fed can increase long-term growth, but the long-run neutrality of money doesn't seem that relevant for the short-run where the goal is merely smoothing out the business cycle.

Also, McCloskey's observation of the small size of the monetary base seems off-target. The Fed's open-market operations directly change the size of the base, but isn't the overall resulting change in the total money supply magnified by the money multiplier effect of the fractional reserve system? Isn't that why it's called just the base? Unless I'm grossly misunderstanding something here.

China selling our bonds wouldn't drive up short-term interest rates, which are set by the Fed.

Unaccustomed as I am to defending Krugman, I have to say that while using the word 'set' is sloppy writing, he's making the valid point that China doesn't 'have a gun to our head'. That's his real point, and he's right.

Btw, I once told Milton Friedman that I thought it would be best to say that, 'the Fed influences interest rates, around a narrow range, and in the short run'. He said he agreed with me.

Eric Falkenstein writes:

Perhaps there's a difference in horizon behind this. For instance, the Bank of England could fix their exchange rate with other currencies as they did for many decades. Yet as 1992 showed--among many such episodes--at some point they couldn't; or rather, it proved too costly and they 'decided' to no longer fix this rate. Within a zone, they can micromanage, but this demands their monetary policy and economic growth are consistent with this targeting.

Jojo writes:

I don't get it--if the Fed can't set interest rates anyway, why hate it so much?

David R. Henderson writes:

@Jojo,
The Drug Enforcement Administration and ICE don't set interest rates either. But I hate them, or, at least, dislike them intensely.
To see some of the harm that the Fed does without setting interest rates, see Jeff Hummel's piece.

David R. Henderson writes:

@Eric Falkenstein,
You're addressing the exchange rate part of his post. I was focusing solely on interest rates.

Bill Woolsey writes:

Hummel's analysis is too focused on changing the growth rate of base money.

How much, if any, is the effect of a shift in the growth rate of base money from 5% to 6% on interest rates in the short run and long run?

If instead, the thought experiment has the Fed adjust base money however much is needed to hit an interest rate target, then the impact will last as long as the Fed wants to put up with possibly bad macroeconomic consequences.

If the changes in base money are temporary rather than permanent, say because there is some nominal anchor other than the growth rate of the quantity of money, even greater impacts on interest rates are possible

Eric Falkenstein writes:

@Henderson: "You're addressing the exchange rate part of his post."

In a Mundell-Fleming model with floating exchange rates it's the same logic.

Consider most Keynesian economists want an easy monetary policy, but at a certain level of inflation this simply becomes too costly, the balance sheet of the Fed would snowball too fast.

Martin writes:

Here's one instance where Krugman writes about not reading opposing views: http://krugman.blogs.nytimes.com/2011/03/08/other-stuff-i-read/

"Some have asked if there aren’t conservative sites I read regularly. Well, no. I will read anything I’ve been informed about that’s either interesting or revealing; but I don’t know of any economics or politics sites on that side that regularly provide analysis or information I need to take seriously. I know we’re supposed to pretend that both sides always have a point; but the truth is that most of the time they don’t."

Jim Glass writes:

What's Krugman's basis for his view that the Fed sets short-term interest rates? Or, another way of asking, where does Hummel go wrong?

Well, the Fed certainly thinks it sets the fed fund rate, as per the NY Fed...

"The Federal Open Market Committee (FOMC) sets a target level for the overnight fed funds rate ... The New York Fed then uses open market operations to change the supply of reserves in the system which, in conjunction with IOER, influence overnight fed funds to trade around this policy target rate or within the target rate range."
...and also its periodic announcements of its decisions to change the rate to specified levels (and more recently its promises not to).

I did read Hummel's piece and didn't see any obvious contradiction of this -- but if a claim is being made that the Fed is mistaken in believing it sets the fed funds rate, where does the Fed go wrong?

Yes, it is only a short-term rate, the Fed certainly doesn't set the range of rates. But the Fed's decisions regarding the level that the fed funds rate is set at are very influential, and have real-world consequences, for better or worse. Does anyone really deny this?

(See for instance the reaction to the Fed's decision to keep the rate up and unchanged at a steady 2% in light of continuing significant inflation risk, as announced on Sept. 16, 2008, right after the bankruptcy of Lehman Brothers.)

Yes, these better-or-worse consequences in the longer-run are bound to have feedback effects through the economy that drive the Fed ultimately to change the rate one way or another sooner or later, as Hummel says (and as per after the Sept. 16th announcement) -- but I don't see how that makes the Fed mistaken in believing it sets the fed funds rate in the short run. And that it is its rate setting decisions that create those feedback consequences. (And today, the Fed sets the Interest on Reserves rate too, also with real consequences. No?)

Philip George writes:

The Fed may not be able to decide the interest rate but by buying bonds at a higher price than the current rate, it can push interest rates lower. The relation is mathematical. The "other things being equal" assumed here is that the Fed's bond purchases and thus injection of money is higher than the market demand for money.

When interest rates did not rise from 2009 to the present Krugman's argument was that this was in some ways a confirmation of everything that Keynes said. Actually, all it showed was that the Fed's injection of money was high enough to keep interest rates down.

The fifth graph of http://www.philipji.com/item/2013-10-20/the-connection-between-corrected-money-supply-and-asset-prices illustrates that.

Arthur_500 writes:

Indeed the Fed sets a target and commences buying and selling bonds in order to attempt to meet that target. So...

China decides to dump US Bonds because they realize that the US is bankrupt and the Administrative and Legislative branches of government have no interest in reigning in their debt. This drives down the value - simple supply and demand.

The Fed then "creates" assets and attempts to drive up prices by manipulating "assets" that many institutions are required to hold. This creates an inflationary situation.

What Mr. Krugman seems to ignore is how little actual power the Fed has. Sure we have QE but everyone realizes it is a failed policy that will be extremely hard to get out of. The only reason we are in any way successful is that the rest of the world sucks worse than us!

Would you like to buy some Greek bonds or some US bonds? Nothing the Fed could do at this point could influence this decision.

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