David R. Henderson  

No, Bill Poole, the Fed Does NOT Set the Federal Funds Rate

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Douglass North, RIP... Always double check your claim...
The Fed does set the federal-funds rate--the overnight interest banks charge to lend to each other--and surely affects the timing of rate changes, but not the longer-run level.
This is the second sentence of an op/ed in this morning's Wall Street Journal by William Poole, currently a senior fellow at the Cato Institute and formerly president and CEO of the Federal Reserve Bank of St. Louis. The article is titled "Don't Blame the Fed for Low Rates."

Poole is an excellent monetary economist, but this is just wrong. Indeed, his own sentence shows that it's wrong. If, as he correctly notes, the federal-funds rate is the interest rate that banks charge in their loans to each other, how could the Fed possibly set it? Moreover, not only does the Fed not set that rate, but also the Fed is not even a participant--as lender or borrower--in the federal-funds market. The most the Fed can do is influence the federal-funds rate indirectly, mainly by using open market operations. But it does not set the rate.


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CATEGORIES: Monetary Policy




COMMENTS (17 to date)
James Hanley writes:

Maybe the common confusion is caused by the word federal appearing in both terms.

Why is it called the federal funds rate anyway, rather than something like the interbank funds rate?

William Luther writes:
Why is it called the federal funds rate anyway, rather than something like the interbank funds rate?
The funds being borrowed/lent by banks overnight are held at the Fed. That's why they are called federal funds.
David R. Henderson writes:

@James Hanley,
Maybe the common confusion is caused by the word federal appearing in both terms.
True, James, that that could explain the common confusion. But it doesn’t explain the wording of someone who was one of the top monetary economists of his generation.
Re your other question, I had thought it was because the banks borrow money on that market to meet the reserve requirements on deposits; these are set by the Fed. But William Luther’s explanation makes sense also.

Jim Dow writes:

It seems like this is mostly semantics. The Fed "targets" the fed funds rate by changing the supply of reserves while it "sets" the discount rate (the rate that the Fed lends to banks).

But if the targeting process is effective in the sense that the deviations are small and average out over time, it's not that far to say that the Fed is setting the fed funds rate by determining its average value in the short-to-medium run. In the context of bank operations, it's the expected value that matters.

SD00 writes:

Confusion is that Fed sends Fed funds *target* rate then uses open market operations to guide the *effective* rate to that target.

It's used rather interchangeably because the Fed is usually fairly accurate:

https://fredblog.stlouisfed.org/2015/09/federal-funds-rate-target-vs-reality/

David R. Henderson writes:

@SD00
Thanks for the link. Here it is as a hot link, for those who are interested.
Note the first 3 sentences of the explanation in the link. It accords with my post:
The traditional policy tool of the Fed is to target the federal funds rate. Note the term target. Indeed, the Fed does not set this interest rate; rather, it sets the target and then conducts open market operations so that the overnight interest rate on funds deposited by banks at the Fed reaches that target. (italics in original)

It then goes on to point out what SD00 says about it being fairly accurate, by which he clearly means “on target:”
Obviously, reaching the target is sometimes harder to do, especially in times when there’s a lot of uncertainty in the markets. The graph above compares the target (or target band more recently) with the effective federal funds rate. While the two coincide quite well over most of the 10-year period, there are important deviations that correspond to various financial market events. Nevertheless, these deviations are short-lived, which shows that the open market operations do have the desired effect.

The fact that it can be different and sometimes substantially so, supports my putting importance on the distinction between targeting and setting.

Stefan writes:

As targets go, the Fed Funds Target Rate is pretty easy to hit. It's a target since the Fed doesn't want to 'guarantee' anything. The bigger issue, even during 'normal' times, is the relationship of the fed funds market to other short term markets.

As short hand phrasing in ed-op articles with limited word count goes, this is not something I'd complain about.

James Hanley writes:
putting importance on the distinction between targeting and setting.

Generally applicable to any public policy. ;)

Michael Byrnes writes:

I think the main reason why this is an important, rather than semantic, distinction is that some of the effects of monetary policy (some would say all or most of the effects of monetary policy) are the result of the OMOs rather than that of the change in the fed funds rate per se.

If the fed funds rate was set by Fed decree, rather than by OMOs, everything we think we know about the fed funds rate and monetary policy would be different.

David R. Henderson writes:

@Stefan,
As short hand phrasing in ed-op articles with limited word count goes, this is not something I'd complain about.
How would using the correct word, “target,” rather than the incorrect word “set,” change the word count?

...the Fed Funds Target Rate is pretty easy to hit.

Actually it isn't. As Paul Volcker found out in the early years of his Fed Chairmanship. The reason is that interest rates are not the price(s) of money.

The price of renting money is an interest rate, but the amount of goods and services that will exchange for money (change its ownership) is the actual 'price of money'. The Fed's Open Market Operations have an effect on both prices, often in opposite directions.

That's why Milton Friedman (and an academic named Ben Bernanke used to) hated the Fed operating through interest rate targeting. It's unreliable...and often produces the opposite interest rate the Fed is presumably looking for. Which is the situation we've been in since 2008; tight money producing abnormally low interest rates.

Greg G writes:

The Fed sets the target for the Fed Funds rate. I suspect Poole was just using "sets the rate" as shorthand for "sets the target for the rate." I doubt very much he really meant that the Fed literally adjusts the rate to a precise number which the market then trades at.

ThomasH writes:

This is a distinction without a difference. If the Fed announced that it would buy or sell enough ST government securities until the Fed Funds rate was X, and then did start buy or selling, it's highly likely that the Fed Funds rate would go to X. Did the Fed "set" that rate or just "influence" it?

Michael Byrnes writes:

Greg G wrote:

The Fed sets the target for the Fed Funds rate. I suspect Poole was just using "sets the rate" as shorthand for "sets the target for the rate." I doubt very much he really meant that the Fed literally adjusts the rate to a precise number which the market then trades at.

I think you are most likely correct, but see David's comment a couple above yours. It's not a necessary shorthand - it is well worth the extra 3 characters needed to be precise.

Many people who ought to know better use this shorthand, and then many who don't know better read it and mistake it for the truth.

Thomas H wrote:

This is a distinction without a difference. If the Fed announced that it would buy or sell enough ST government securities until the Fed Funds rate was X, and then did start buy or selling, it's highly likely that the Fed Funds rate would go to X. Did the Fed "set" that rate or just "influence" it?

It is not a distinction without a difference. Monetary policy would look superficially similar if the Fed set the rate by decree, but it would work very differently.

Expanding/contracting the monetary base, or merely threatening to do so, affects the economy in various ways, many of which have nothing to do with the fed funds rate.

Imagine that the US government wants the price of oil to be fixed at $50 per barrel. It could try to get there in (at least) three different ways:

1. Pass a law stating that oil must be bought and sold at $50 per barrel.
2. Announce that the strategic petroleum reserve will target a price of $50 per barrel by buying and selling unlimited oil at a that price. (Note that in this scenario, if the public believes this is a credible policy, it will tend to get to this price without major OMOs, as with the Fed's interest rate target).
3. Announce that the Fed will target an oil price of $50 per barrel by expanding/contracting the monetary base.

All three would lead to oil selling at $50 per barrel, but they are 3 vastly different policies with vastly different impact on the oil market and the economy as a whole.

Lawrence D'anna writes:

This seems like a really pedantic distinction to be insisting on. The Fed targets the funds rate quite precisely using open market operations. I think everyone understands that's what it means to save the Fed sets the rate. In the long run the Fed Does not have a lot of freedom to set the rate to whatever it wants if it also wants to maintain price stability but that doesn't seem to be your point. Why is the distinction between setting the rate and targeting it and important difference?

Michael Byrnes writes:

@ Lawrence D'anna

The distinction matters because "setting rates" is a price control. People (banks are people) who want to lend/borrow at a different rate are barred from doing so.

"Targeting rates" isn't a price control. People who want to lend/borrow at a different rate are free to do so.

The Fed's OMOs influence the rates people are willing to lend/borrow at, but they are still free to engage in what they believe are mutually beneficial transactions. At some level, what the Fed does is not all that different from what OPEC tries to do with the oil supply - if they want a higher price they can try to cut back on production.

James Alexander writes:

All the above is a lovely discussion and actually quite helpful in a nerdy sort of way. The big problem with Poole's OpEd is that he is wrong NOT to blame the Fed for low rates. It is their fault, caused by too tight money.

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