David R. Henderson  

Selgin on Money

Everything You Ever Wanted to ... Keep it simple, and pay attent...

George Selgin, over at Cato, is writing a primer on monetary policy and his first installment appeared this morning. It's excellent.

Maybe not surprisingly, what I will excerpt here makes the point that Jeff Hummel and I have been making for some time: the Fed does not set or control interest rates. George writes:

If the money-supply effects of central bank actions aren't always predictable, the interest rate effects are still less so. Interest rates, excepting those directly administered by central banks themselves, are market rates, the levels of which depend on both the supply of and the demand for financial assets. The federal funds rate, for example, depends on both the supply of "federal funds" (meaning banks' reserve balances at the Fed) and the demand for overnight loans of the same. The Fed has considerable control over the supply of bank reserves; but while it can also influence banks' willingness to hold reserves, that influence falls well short of anything like "control." It's therefore able to hit its announced federal funds target only imperfectly, if at all. Finally, even though the Fed may, for example, lower the federal funds rate by adding to banks' reserve balances, if the real demand for reserves hasn't changed, it can do so only temporarily. That's so because the new reserves it creates will sponsor a corresponding increase in bank lending, which will in turn lead to an increase in both the quantity of bank deposits and the nominal demand for (borrowed as well as total) bank reserves. As banks' demand for reserves rises, the federal funds rate, which may initially have fallen, will return to its original level. More often than not, when the Fed appears to succeed in steering market interest rates, it's really just going along with underlying forces that are themselves tending to make rates change. (italics his)

I haven't put in the links that are in this paragraph in George's original. For those, go to George's post.

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CATEGORIES: Monetary Policy

COMMENTS (10 to date)
ThaomasH writes:

I'm not sure if I disagree or do not understand your point. The Fed DOES control ST interest rates to the degree they wish if they wish determinedly enough to buy and sell ST assets to achieve their wish.

Thus far the Fed has never wished to control yields on longer term assets. During QE the just announced a rate of purchase leaving the yields to fall out, but there is little doubt that if the Fed wished the yield on the 10 year Treasury bond to be X% and was willing to buy and sell unlimited amounts of them, they could get the rate arbitrarily close to x%.

Now an excellent case can be made that interest rate targeting is not a good idea and that the announcement that the Fed was going to raise ST rates by 100 basis points withing one year from last December was a mistake, it WAS a mistake because they COULD have done it.

David R. Henderson writes:

there is little doubt that if the Fed wished the yield on the 10 year Treasury bond to be X% and was willing to buy and sell unlimited amounts of them, they could get the rate arbitrarily close to x%.
There is in fact, much doubt.

George Selgin writes:

Thomas, you will find evidence bearing on this matter by following the link in my original post.

In fact, the Fed has not been able to "target" the ffr with any degree of precision since the fall of 2008, when the effective rate fell below the Fed's target despite the Fed's efforts to prevent it from doing so. The Fed then responded by changing its target, or rather by replacing it with a "band" defined by the IOER rate on one hand and the overnight repo rate on the other. The effective rate could not fail to fall within such a band. But then, were I allowed to toy thus with targets, I might be able to proclaim myself the equal of William Tell!

James writes:

Saying "the Fed does not set or control interest rates" seems like an exercise in insisting on very strict definitions of "set" and "control" in order to get away with making a seemingly outlandish claim. I understand the prankish fun in this but it might be worthwhile to consider the value of continuing to use such strict definitions with words that are already in common use by normal English speakers. For the same definitions, the following are also true:

The Department of Defense does not set or control the number of B-52s in the US inventory. State governments do not set or control highway speeds. Supervisors at fast food restaurants do not set or control the hours of their employees. Price ceilings do not set or control maximum prices. Price floors do not set or control minimum prices. Contracts do not set or control the behavior of the parties who sign them. Billiard players do not set or control the balls on the table. Scott Sumner was not in control of his car for even one second the last time he got behind the wheel.

Why not use plain English and say that a central bank sets or controls whatever variables with the uncontroversial caveat that no government agency absolutely controls anything?

George Selgin writes:


Set: put, lay, or stand (something) in a specified place or position.

Control: determine the behavior of.

The Fed does neither of these things to interest rates, except to an extremely limited degree. You may not believe it, but the problem then isn't my choice of words.

George Selgin writes:

I cannot resist adding that if Scott Sumner controlled his car the way the Fed controls the federal funds rate, he would have been unable to avoid driving it off a cliff eight years ago.

ThaomasH writes:


I'd like to see the explanation of how, no matter how much the Fed was willing to buy of long term treasury securities, they could not force the yield down to X%. What if they bought every last one? This sounds like the claim some folks have made that a minimum wage will not result in unemployment. Is seems like a denial that demand/supply curves slope down/up.

Please elucidate.

George Selgin writes:

ThomasH: It's a peculiarity of money that, because of its role as means of exchange and unit of account, whatever increases its availability also tends to cause aggregate demand, and thence general prices, to increase, other things equal. If I buy a bunch of government bonds, I must buy less other stuff. My actions will (again, other things equal) tend to raise the price of and reduce the yield on the bonds. But they will not tend to lead to any general increase in prices.

That matters, because an increase in aggregate demand means a general increase in incomes and in demand for borrowed funds, including the governments' demand for such. In the long run, the nominal supply of bonds increases enough to offset the increase in demand, putting yields back where they started.

The story is but one aspect of the general notion of "long run monetary neutrality." Double the money supply (or the monetary base); ceteris paribus, all nominal magnitudes double, relative prices and real quantities end up the same as before. You consider it counter-intuitive. But monetary economists consider it one of the great insights in their field.

James writes:

George Selgin:

How closely would the actual fed funds rate have to track the target for you to say that the Fed controls it?

George Selgin writes:

James: Close tracking is necessary, but not sufficient: there still would remain a problem of distinguishing the dog from the tail. A powerful presumption exists in favor of the view that monetary forces are a but player in a drama in which other factors -- impatience and productivity of capital -- are the big players.

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