Janet Yellen’s latest testimony before the Senate Budget Committee confirmed my long-held belief about the Federal Reserve: People give the institution way too much credit.
Too many people seem to assume that the Fed can achieve almost any economic goal. Need a new regulator of insurance companies and asset management firms? Let the Fed do it. Inequality on the rise and the middle class is shrinking? Let’s get the Fed on it. Job training and childhood education? Why not see what the Fed can do?
And that’s on top of the more traditional macro topics. Folks seem to think the Fed can raise or lower inflation at will and, if given enough time, fix the employment situation.
To Yellen’s credit, she told the senators that many of these issues were outside the realm of what the Fed can achieve with monetary policy. But there’s no doubt Yellen – not to mention most mainstream macroeconomists – wholeheartedly believe monetary policy can fix inflation and unemployment.
I won’t rehash the age-old debate on whether there’s a tradeoff between inflation and unemployment, but I do want to go into the popular view that the Fed controls interest rates.
This idea shows up routinely in the mainstream press – and even in specialized publications like American Banker. Journalists across the spectrum use phrases such as “the Fed will raise interest rates” and “the Fed may have lowered rates too much.” But does the Fed really have that much control over interest rates? All of them?
In terms of market rates, the Fed doesn’t actually claim to set rates. It only sets a target range for its main policy instrument, the Federal Funds Rate. Based on this target, the Fed then buys and sells securities to impact the supply and demand of bank reserves, ultimately moving the fed funds rate toward its target.
It’s widely taken for granted that these operations influence all short-term interest rates and even long-term interest rates. But do open market operations really give the Fed control over rates? Can they make money market rates, for example, any value they want at any time they choose?
While some mainstream macroeconomists argue the Fed can control rates to this extent, there’s actually quite a bit of disagreement across the broader academic community. Among financial economists, for instance, the proposition that the Fed does not have this sort of absolute control is not too controversial.
I’m certainly not the first to argue historical evidence and general context strongly point to a Fed that does not have this much control (influence, yes; control, no).
Diedre McCloskey, for instance, pointed out in 2000 that the Fed’s open market operations constitute a very small part of the world’s capital markets. McCloskey highlighted that, in a capital market of approximately $300 trillion, the Greenspan Fed typically increased or decreased its bond holdings in the neighborhood of $40 billion per year.
Beyond those numbers, there’s basic supply and demand. If, for example, the worldwide money market rate is 4 percent, how could the Fed’s open market operations sink that rate to 1 percent?
Presumably, the Fed could purchase every Treasury security it could find. Let’s assume that these operations are initially successful in that they sink the Fed funds rate and U.S. money market rates start to drop.
Absent explicit prohibitions, there’s no way to prevent U.S. investors from taking the higher rates abroad, so people would invest in non-U.S. based funds. Maybe the massive U.S. exodus would cause a price increase (and rate decrease) in the foreign funds, but then we’d also see a price drop (and rate increase) in U.S. funds. Those rates can’t get too far apart for too long.
There are also some other issues in the fed funds market that cast doubt on the Fed’s ability to simply “hit” any rate it desires. That market centers around the short-term lending of banks’ reserves, a measure that is impacted by open market operations, discount window borrowings, and autonomous factors that the Fed can’t control. (For instance, people sometimes do take money out of banks unexpectedly.)
Every day the Fed forecasts all these factors to conduct open market operations in a way that is consistent with its target for the Fed funds rate. It’s no secret that these forecast errors can be quite large.
Lending of reserves is almost always conducted on a case-by-case basis between banks that are free to negotiate their own contracts. The rate the Fed actually targets is a quantity-weighted average of rates reported by five large brokers. Yet a great deal of interbank lending is not done through brokers.
A general overview of the data also suggests the Fed funds rate – and, consequently, the Fed’s target – is constrained by market factors. From 1982 to 2012, for instance, the Fed funds rate went from approximately 12 percent to almost zero. If the Fed can control the rate and it wants stability, why such a large range?
It’s also well documented that the Fed funds rate has deviated from its target on more than one occasion (both within and across days). Combined, these facts suggest the Fed does not have precise control of short-term interest rates—to say nothing of the longer term rates that are not directly tied to traditional open market operations. (There’s also the fact that 10-year Treasuries have been moving in the opposite direction the Fed has been trying to push them.)
Precise, definitive empirical tests of this question – can the Fed control interest rates – will probably evade us forever. But we don’t really need them if we think carefully and if we just listen to what Ben Bernanke has told Congress: “The only way to get interest rates up is to get the economy growing again so that returns will be adequate, not just for fixed income instruments but for other kinds of assets as well.”
Or, we could listen to what Yellen told the Senate Budget Committee (paraphrasing): Interest rates are unlikely to start rising until we have a stronger economy.
On the other hand, I’m not sure how much we should trust central bankers.
Originally appeared in Forbes.