There is a new interview available in David Beckworth’s series of money/macro podcasts. This time it’s with me.
I’m also happy to announce a new Mercatus working paper by Jeffrey Hummel, on a topic that’s dear to my heart—the myth of central bank control over interest rates.
Before discussing this idea, I need to reassure readers that both Jeffrey and I acknowledge that on any given day the Fed is able to raise or lower the fed funds rate, through suitable adjustments in monetary policy. But that true fact leads many non-economists, and unfortunately even many economists, to wildly excessive views on the extent to which the Fed “controls” interest rates. The deeper mistake is to confuse the path of interest rates over time with “monetary policy”. Here is the abstract to Jeffrey’s paper:
Many believe that central banks, such as the Federal Reserve (Fed), have almost total control over some critical interest rates. Serious monetary economists are more sophisticated. They realize that central bank control over interest rates is very far from complete. Nonetheless, central bank officials and many economists are largely responsible for the popular misapprehension. This is because they persistently and misleadingly describe central bank policy as if it determined interest rates. Their focus on interest rates as both the target and indicator of monetary policy stems from the fact that even those holding the sophisticated view of how monetary policy works tend to overestimate the strength and significance of a central bank’s limited effect on real interest rates. There is no denying that central banks have some impacts on interest rates, in both the short run and the long run. However, this working paper argues that not only is the popular belief in precise central bank management of interest rates simply wrong, but also even the sophisticated view of central bankers and mainstream monetary economists turns out to be overstated. In fact, continued targeting of interest rates by central banks has even led to some confusion and policy errors.
The entire paper is well worth reading.
I’d also like to add my own perspective. One way to think about Fed control is with the concept of policy discretion–freedom to move rates at the whim of the FOMC. Just how much freedom does the Fed actually have?
1. Let’s start with Wicksell’s concept of the natural or equilibrium rate. He defined the natural rate as the interest rate that led to price stability. If the Fed pegs the expected future value of the CPI at a constant level, then it would have zero freedom to control interest rates. In that case the market would set interest rates at the level expected to lead to price stability. The same argument applies to a 2% inflation target, an NGDP target, or any other similar policy regime. Let’s call this “perfect policy” and it implies zero central bank control over interest rates. The Fed simply follows the market.
2. Of course in the real world, policy is not always perfect. But this doesn’t have the implications for policy discretion that many people assume. Suppose the Fed sets the interest rate target at a level 1/2% below the Wicksellian equilibrium rate, and then leaves it there. Thus they peg the rate at 1.5% when the Wicksellian equilibrium rate is 2.0%. What happens next? The simple answer is that the system blows up. The expansionary monetary policy causes inflation expectations to steadily rise. If the central bank stubbornly continues to peg the fed funds rate at 1.5%, then the actual (nominal) interest rate falls further and further below the (nominal) Wicksellian rate, which is rising sharply with higher inflation expectations. Thus setting the policy rate below the Wicksellian rate causes policy to become increasingly expansionary over time, ultimately leading to hyperinflation. At that time the system blows up, and people stop using the now worthless currency produced by the central bank. Let’s call this the “disastrous policy”.
3. If “perfect policy” is an unrealistic assumption for actual real world monetary policy, then “disastrous policy” is even more unrealistic. The roughly 1.95% average inflation experienced since 1990 is closer to the Fed’s notion of “price stability” than it is to hyperinflation. So let’s now consider the only case that really matters–imperfect policy that roughly but not perfectly adheres to the Fed’s dual mandate, while also making occasional errors. In order to better understand the role of errors in creating central bank control over interest rates, it will be helpful to distinguish between small errors (1922-29, 1983-2007) and large errors (1929-33, 1966-82 and 2008-13).
A. When there are large errors the macroeconomy will move far off course. Does this give the Fed a lot of control over interest rates? Actually it doesn’t, unless the Fed wants the system to blow up. Thus LBJ and Nixon wanted a low interest rate policy to spur growth. And for a brief period the Fed delivered. But very quickly the Fed had to reverse course and raise rates to restrain inflation (caused by the earlier error). The much more important moves in interest rates during the late 1960s and 1970s were higher not lower, despite a brief dip in rates associated with the Fed’s expansionary policy. Many people wrongly attributed the higher interest rates to a discretionary Fed “tight money” policy, when they were in fact a product of a sharply rising Wicksellian interest rate, which was caused by higher inflation (or more specifically NGDP growth) expectations.
The same applies in the reverse direction. The ECB used its “control” over interest rates to raise then 1/4% in July 2008, but the effect was so negative that the ECB had to cut them sharply over the next few years. Those cuts were not “monetary policy”, they reflected a weakening economy depressing interest rates, and the ECB following along. (Interest rates used to fall during recessions even before the US had a central bank.) The ECB made the same mistake in the spring of 2011, raising rates by 1/2%. Once again, the eurozone economy tanked and the ECB had to dramatically reduce rates over the next few years.
The bottom line is that during periods of policy failure, the big swings in interest rates do not reflect discretionary decisions of central banks, but rather are moves that are forced on central banks by their desire to prevent hyperinflation or hyperdeflation. So when there are big policy errors, the big moves in market interest rates mostly do not reflect central bank “control” over rates—indeed just the opposite, rates moving in the opposite direction from the original policy error that created the disturbance.
B. What about small policy errors? Yes, the central bank has some control over rates in the short run, and can use that control to create small policy errors. But the irony here is that the closer policy approaches perfection, the less discretionary control is available to the central bank. In contrast, when errors are larger, the absolute level of control over rates is larger, but macroeconomy produces proportionally larger swings in inflation and NGDP growth, so the share of interest rate movements that reflect “monetary policy” remains quite small. Most moves in interest rates reflect shifts in GDP growth and/or inflation, which were in turn created by previous policy errors.
There are powerful cognitive illusions here. The day-to-day Fed “control” over rates creates the illusion of much more control than actually exists. Monetary policy is much more than a series of short run decisions on where to set the fed funds target. By analogy, a bus driver going through the Alps has very good short term “control” over the direction of the bus. He can nudge the bus left or right by turning the steering wheel. But over longer stretches of time the direction of the bus is “controlled” by a combination of the direction of the road (i.e. economy) combined with the bus driver’s strong desire than he and his passengers don’t hurl over the edge to a terrifying death (i.e. hyperinflation/hyperdeflation).
Hong Kong is a good example of a country with almost no control over interest rates. Why is that? Perhaps because monetary policy in Hong Kong is nearly “perfect”. Their monetary authority decided to target the exchange rate rather than inflation. More specifically, the HK$ has been pegged at roughly 7.8 per US$ since 1983. That’s pretty close to perfect, given their policy goal (which may or may not be a wise goal.) That success creates credibility, and thus the exchange rate is expected to stay at this level. As a result, interest rates in the Hong Kong move in tandem with rates in the US.
A common mistake is to assert that while the income effect and the Fisher effect are important “in the long run”, current interest rate changes reflect Fed control. Wrong! The long run is right now. “Current” is not the opposite of “long-run”, rather short run is the opposite of long run. Perhaps 10 percent of current moves in interest rates reflect Fed “control”, while 90 percent reflect the long run income and Fisher effects of actions taken earlier.
Although I don’t count myself as a NeoFisherian, their view is in some ways less inaccurate than the conventional view. It’s not always the case that higher interest rates reflect an easy money policy, but it’s much more likely to reflect the long run effects of an easy money policy, than it is to reflect the short run effect of a tight money policy. So if someone put a gun to my head and forced me to believe that the Fed controls interest rates, I’d become a NeoFisherian and argue that they control them by controlling inflation and NGDP growth, not via the liquidity effect.
PS. Moving has recently pre-occupied my time. An hour ago I learned that I won’t get my furniture (including computer) for at least another week, much longer than they promised. So we’ll continue to camp out in our home for quite some time.