Matt Yglesias has a new post that explains the Fed in 20 questions. He gets off to a good start:
1. What’s the Federal Reserve System? It’s America’s central bank.
But then starts to struggle a bit:
2. What’s a central bank? A central bank is many things. But what makes it a “central bank” is this. When banks take deposits they lend most of that money back out. As a regulatory matter, however, they are not allowed to lend all of it out. They have to hold some of the money back as reserves. Those reserves are placed on deposit with the Fed. Hence “Federal Reserve.” It’s central in the sense that it stands at the center of the banking system; the bank where banks do their banking.
3. Why’s that important? It’s actually not that important.
Let’s look at bank reserves in late 1914, when the Fed was getting up and running:
Date Vault Cash Deposits at Fed Reserves
Sept. 1914 $1.662 billion $0 $1.662 billion
Oct. 1914 $1.642 billion $0 $1.642 billion
Nov. 1914 $1.452 billion $0.228 billion $1.680 billion
Dec. 1914 $1.352 billion $0.244 billion $1.595 billion
When the Fed was created it simply moved a small portion of reserves that were held in large denomination currency (up to $100,000 bills) into an account at the Fed. This was done to make interbank transfers easier. It reduces armored car robberies. That’s all. It’s a big mistake to make bank deposits at the Fed the centerpiece of what makes a central bank. Instead, here’s what Matt should have said:
2. What’s a central bank? A central bank is many things. But what makes it a “central bank” is this. The central bank has a monopoly on the production of the monetary base, which is almost always the medium of account, or at least one of two media of account.
3. Why’s that important? If it is the only medium of account (as under fiat money), then the monopoly on the production of base money, combined with the ability to produce base money at near zero cost, gives the Fed almost unlimited ability to influence the value of money.
4. But why is that so important? Because most wages, prices and debt contracts are denominated in money terms. If you change the value of base money, it influences all other nominal values in the economy. Even more importantly, many wages and prices are sticky, so it also influences all sorts of real variables, such as real GDP and employment, at least in the short run.
Matt Yglesias continues:
5. So what’s monetary policy? That’s a bit of a metaphysical issue. In a sense, “monetary policy” is just a word for “stuff central banks do to try to keep growth on track and inflation in check” and doesn’t refer to anything in particular. In practice, there are two main things the Fed does to try to do monetary policy—it manipulates interest rates and it tries to shape expectations about the future.
6. How does the Fed manipulate interest rates? Traditionally the overwhelming focus of monetary policy has been moving the “federal funds rate” up and down. That’s the rate that’s been at-or-near zero since the crisis began.
This disappointed me. Matt’s much brighter than I am, and has studied philosophy. He’s very good at logic. But unless I’m mistaken, he never answers the question of HOW the central bank manipulates interest rates. He seems to say the Fed manipulates interest rates by manipulating a specific interest rate. The fed funds rate is their target, but how do they hit the target? It’s not an administered rate like the discount rate; it’s set in the interbank loan market, between private firms. How does the Fed control this rate?
7. What’s the federal funds rate? It’s the interest rate at which banks can lend reserves to each other overnight to make up for short-term funding gaps.
8. Is that really so important? Sort of. In a sense this is the foundational interest rate upon which lots of other interest rates are based. A higher federal funds rate propagates through the economy resulting in higher mortgage rates, higher auto loan rates, higher small business rates, etc. reducing investment and durable goods purchases and slowing the economy down. In another sense, though, the federal funds rate is important because it’s a symbol that shapes expectations.
But a symbol of what? It seems to me that Matt is desperately trying to avoid getting down into the gutter with us market monetarists, and talking about the monetary base. Smart macroeconomists don’t discuss the base; it’s too low class. They talk about interest rates. And if they are especially smart they talk about the future expected path of interest rates. But we still don’t know how the Fed controls interest rates!
Here’s how I would answer question 8:
8. Is that really so important? Not in and of itself. It’s an epiphenomenon that occurs when the Fed adjusts the supply or demand for base money. (I haven’t mentioned demand yet, but the Fed also influences that variable.) However when the Fed changes the supply or demand for base money it does have a short run effect on the Fed funds rate. In addition, the Fed usually targets the fed funds rate. If you combine those two facts, changes in the fed funds rate target provide an indicator as to whether monetary policy is getting more expansionary or contractionary. But only in the very short run, because the long-run effect of monetary policy on interest rates is different from the short run effect.
If the Fed cuts the Fed funds rate target, it suggests that the Fed would like to see faster NGDP growth. To achieve faster growth, the Fed will increase the current and future expected level in the monetary base. This will cause the Fed funds rate to decline right now. The effect on longer-term interest rates is ambiguous. But regardless of whether longer-term interest rates rise or fall, the effect on nominal GDP growth is expansionary.
PS. You might argue that bank deposits at the Fed were a small share of the base in 1914, but in modern central banking they are very important. But that’s only true since 2008. As late as 2007 bank deposits at the Fed were only about 1% of the monetary base, an even smaller share than in 1915 (when it was about 4%.) The US banking system was more cash-oriented in 2007 than in 1915. In 1915 we had a more “sophisticated” monetary base than in 2007.
There’s no “metaphysics” at all. As late as 2007, “monetary policy” was 99% printing currency and minting coins. All the rest was the “effects” of monetary policy.