Monetary policy and interest rates

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.



27 Responses to “Monetary policy and interest rates”

  1. Gravatar of msgkings msgkings
    2. August 2017 at 11:55

    Very informative summary, thanks.

    Sorry about your furniture. Thanks Obama.

  2. Gravatar of Major.Freedom Major.Freedom
    2. August 2017 at 13:33

    Why did you start your analysis with an appeal to the fallacious doctrine of “price stability”?

    In a healthy laissez faire market subject to individual private property rights, *Prices fall**. They are not “stable”.

    All that needs to be said in regards to centralized counterfeiters affecting interest rates is that in the absence of such counterfeiters, prevailing interest rates would be different than they are now.

    Price stability is as dangerous and destructive an ideal as aggregate spending stability.

    We don’t need the price of bread to be stable over time.

    And since when did “stability” mean rising every year by a positive percent? That isn’t stability. That is a joke.


  3. Gravatar of Major.Freedom Major.Freedom
    2. August 2017 at 13:35

    Theory of interest rates Sumner is using stems from long ago refuted frameworks as general equilibrium. We are never at equilibrium. We are never at rest. There is an absence of time and of the market process, in Sumner’s catalogue.

  4. Gravatar of Matthew Waters Matthew Waters
    2. August 2017 at 15:15

    I’m asking an honest question: Does the paper comment on the effects of the Fed buying longer-term assets? Could the Fed’s asset mix itself affect the yield curve?

    The common-sense argument is things like QE2 or “Operation Twist” would lessen the supply of longer-term assets. If you had S and D curves for 10-year assets, it would move the S curve to the left, raising prices (i.e. cutting interest rates).

    Would you say higher inflation expectations overwhelm the decline in supply? That does seem to happen in practice, but the actual mechanics make my mind hurt. The simplest mechanic is the Fed reduces the supply of longer-term bonds, flattening the yield curve. I realize this explanation does not match the evidence.

  5. Gravatar of Benjamin Cole Benjamin Cole
    2. August 2017 at 15:53

    Excellent blogging.

    BTW, Hong Kong has the world’s least affordable housing, for its citizen-residents.

    “Hong Kong kept its ranking as the world’s least affordable urban centre to buy a home for the seventh year running, in a survey that’s likely to throw a perennial problem back into focus during an election year for the city’s chief executive.
    The city’s apartments cost 18.1 times gross annual median income in the third quarter of 2016, according to the Demographia International Housing Affordability Survey’s study of 406 cities around the world. That’s a slight improvement from the 2015 study, which stood at a record 19 times income, according to Demographia.”


    The world’s second-least affordable city is Sydney.

    Both Australia and Hong Kong run chronic current account trade deficits.

    It is becoming clear that monetary policy might be able to torpedo property values (a central bank can raise rates high enough) but property appreciation is not dependent on monetary policy or even underwriting standards (Australia has recourse loans and requires private mortgage insurance if LTV ratios are too low).

    A challenge for macroeconomic policy-makers is to devise policies that do not result in property prices that outstrip employee-incomes. The middle-class can no longer buy housing in Great Britain. A tight monetary policy, by restricting the supply of new real estate product, can actually make matters worse.

    PS: I wonder.

    Yes, long-term interest rates are market-determined.

    Yet it seems to me the Fed can tighten up, and that property mortgage rates, which are long-term, do rise.

    Volcker jacked up rates, and mortgage rates went to double digits (and even close to 20%).

    In 2007 the Fed jacked up rates, and again mortgage rates rose with disastrous effects on real estate markets.

  6. Gravatar of ssumner ssumner
    2. August 2017 at 17:57

    Msgkings, Didn’t Congress roll back those regulations?

    Matthew, Yes, buying bonds reduces the supply available to the public, raising prices. But it also reduces demand, which lowers prices.

    It’s been a few months since I read Hummel’s paper, so I don’t recall exactly what he said on that issue.

  7. Gravatar of Cloud Cloud
    2. August 2017 at 19:07

    For the HK part, I think you only mean the linked exchange rate is “perfect”in the sense that it established credibility and the monetary policy is rigid as intended right?

    You don’t mean that it is “perfect” in the sense that the interest rate in HK is very close to the natural rate in the region, I assume. Haven’t really check it yet, but I suppose that the NGDP is quit volatile……

    I think we in HK are staying very close to the natural rate of the US, and it is actually quite an interesting counter example to your main point in the article. I think the supposed deviation from the natural rate in HK (which I simply assumed without much proof) is pushing the economy overheat in here. Exhibit A would be our home prices. Exhibit B would be the fact that our interest rate now has trouble following through the rate hike of the US (though in the very recent weeks, it started moving closer to the US rate, which may prove your point is valid in longer run)

    I am not sure how to reconcile all these actually. I would love to hear you tell us more your views on the HK monetary system~~

  8. Gravatar of Benjamin Cole Benjamin Cole
    2. August 2017 at 20:25


    The problem with Hong Kong housing prices is probably better explained by property zoning (which curtails supply) and current account trade deficits.

    We have the study, “House Price Booms, Current Account Deficits, and Low Interest Rates,” by Andrea Ferrero, a version of which appeared in the Journal of Money, Credit and Banking, and which also has been presented as a study by the New York Fed. Ferrero concludes, “Yet, monetary policy factors play virtually no role for house prices and the current account.”

    Ferrero posits nations with large current account trade deficits face house-price booms.

    As if that were not enough, another article from the Journal of Money Credit and Banking, entitled “Capital Inflows and the U.S. Housing Boom” Filipa Sa and Tomoasz Wieladek comes to the conclusion, “Our findings suggest that capital inflows that result from ‘saving-glut’ shocks have a positive and persistent effect on real house prices and real residential investment.”

    Oh gee, huge foreign capital inflows into US real estate raise values?


    Also, see the amazing chart here on current account trade deficits and house prices. Like a mirror!

    Hong Kong runs large chronic trade deficits. Housing values are exploding. Good luck with taming that through higher interest rates.

    Hong Kong options are (like those of Great Britain, U.S., Canada, Australia, New Zealand):

    1 Build a lot more housing or

    2. Run a balanced trade policy.


    3. Watch housing prices escalate beyond the reach of the bulk of the population.

  9. Gravatar of Cloud Yip Cloud Yip
    2. August 2017 at 22:14


    Thanks! I love your comment! I learn a lot from it.

    I should do some serious digging first. But my quick reaction is that I agree with your point that the problem is in current account deficit. But I would add that the current account deficit is a mirror image of the Chinese capital inflow (I think I need more evidence on here, but I think this is the general tendency). It is hard to simply argue that low interest rate attract capital inflow, but I would argue that inappropriate interest rate level (maybe deviation from the natural rate) push up asset prices, and attracted inflow from China seeking relatively “safe” (from political factors) assets which have constant appreciation in value.

    This analysis is quite rough, please forgive for that. But I do believe that HK is suffering from a problem of inappropriate monetary stance, a result of the outdated linked exchange rate level, which makes HK economy more volatile than optimal.

    Please feel free to point out any non sense from my arguments. I love to hear more analysis on HK economy from all of you.

  10. Gravatar of Jerry Brown Jerry Brown
    2. August 2017 at 22:39

    It seems to me that a central bank could always determine the risk free interest rate if it wanted to do that. Just like I could leave my driveway and floor the gas pedal until a bad thing happened. That I don’t want to smash my car doesn’t mean I don’t have control of it.

  11. Gravatar of EB EB
    3. August 2017 at 04:12

    Thanks Jerry Brown for your excellent comment. Scott and many other economists ignore your point for reasons that I don’t want to speculate but it is obvious to anyone that has studied the history of inflationary financing over the past 200 years. Yes, sometimes there are drivers that floor the gas pedal knowing that most likely they will smash the car but almost all drivers usually don’t want to commit suicide or kill someone else. Indeed, once we acknowledge your point there is nothing interesting or special about central banks (thus why Scott in his post
    has to assume that there is a Janet Yellen is a best driver –a nonsense assumption).

  12. Gravatar of Benjamin Cole Benjamin Cole
    3. August 2017 at 04:54

    OT but interesting.

    The Fed says there are “labor shortages” in America. Set aside that a “labor shortage” is an odd non-economic expression, meaning that supply and demand are not the ruling concepts.

    Be that as it may, Amazon is offering $12 an hour, and having job fairs, but you have to wait in line for hours just to get interviewed. People turned out by the thousands to stand all day in line in parking lots etc.

    From the news—

    “Amazon is promising to hire 50,000 people in one day at job fairs across the country.

    The events are drawing thousands of people to Amazon fulfillment centers in Maryland, Massachusetts, New York, Tennessee, Illinois, and seven other states.

    The popularity of the fairs is leading to excessively long lines for registration and interviews.”


    You think we might have a “job shortage”?

  13. Gravatar of Andrew Andrew
    3. August 2017 at 05:55

    Not related to your post at all, but related to some of your ideas;

  14. Gravatar of ssumner ssumner
    3. August 2017 at 07:59

    Jerry, I think you missed the whole point of the post.

    EB, You said:

    “thus why Scott in his post
    has to assume that there is a Janet Yellen is a best driver –a nonsense assumption).”

    That’s wrong on so many levels I hardly know where to begin. But no, I never assumed that Janet Yellen was the best driver.

  15. Gravatar of ssumner ssumner
    3. August 2017 at 08:52

    Thanks Andrew, I’ll do a post.

    Cloud, Good question, and I sort of agree with you. I’ll do a post in a day or two at Econlog, answering your question.

  16. Gravatar of Jerry Brown Jerry Brown
    3. August 2017 at 09:13

    Scott, it is true that I may have missed the whole point of the post- it happens occasionally. What was the point of it? I thought you were trying to dispel some “myth of central bank control over interest rates”. Which I do not think is a myth as far as it pertains to the risk-free interest rate.

  17. Gravatar of Major.Freedom Major.Freedom
    3. August 2017 at 09:40

    “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.”

    But that’s just it, just like you the Fed is not able to parse the causes of “current” movements into rather dubious single percentages for short run and for long run.

    The Fed is constantly faced with a set of information that the Fed itself has distorted away from market, over the long run. It cannot look at current rates and know how much was caused by what it did in the last 6 months and how much was caused by what it did prior to 6 months ago.

    In other words, what you may believe to be a “good” quantity of counterfeiting today, is actually based on an unfounded belief that the Fed is today somehow able to fix whatever ails the quantity of money and spending as if doing so wasn’t already done in the past that caused the very “problems” the Fed is now tasked by socialists to act to “fix” today!

    The Fed is constantly chasing its own tail, and will never integrate itself cohesively and harmoniously with the wider ecomomic activity predicated on a totally different, indeed opposite, set of rules. The Fed does to play by market rules, no matter what deceitful name you want to give your arbitrary anti-market counterfeiting rule.

    You have named your arbitrary anti-market rule to include “market” to intentionally deceive people into believing the rule is market force driven, when it is not at all. It is NOT a market driven rule to have state imposed ex-market pencil necks throw feces at the wall and conclude that because the Fed has tended to counterfeit “this” way in the past, that some statistic associated with it is deemed by forc elf government guns, to be the new rule, and after that, the non-existent “market” will then “decide” everything else that has up to today been the subject of rules by the Fed.

    Any rule the Fed uses to counterfeit, will NEVER be a market driven rule. The choosing of 4.537563837564839% NGDP *instantly* eliminates any possibility of market driven spending, interest rates, or prices.

    What you are doing with this paper, is lying to your readers to brainwash them into believing two key lies:

    1. The lie that by shifting the rule from interest rates to spending, that this makes interest rates “market” driven. Yet you have already attributed NGDP changes to the Fed despite the fact that it isn’t “targeting” it. Well, the fact that the Fed can affect NGDP even when it isn’t trying to target it, is the same freaking way the Fed can affect interest rates without targeting them. Changes in money result in new value judgments by individuals for ALL things money related, interest rates, prices, spending, money holding, you name it. The Fed is making a mess of all of these stats no matter what they target.

    2. The lie that should the Fed no longer intentionally directly target interest rates, that this will somehow magically covert all interest rates into “market driven” rates should the Fed counterfeit at a different rate.

    It doesn’t actually matter to this point what the Fed people have in their minds when they counterfeit at rate X versus rate Y. It doesn’t matter if they are counterfeiting so they can see the price of bread rise by an arbitrary percent, or if they are counterfeiting so they can see many prices of many goods rise by an arbitrary percent calculated by an arbitrary set of goods weightings, or if they are counterfeiting so that they can see total business revenues change by an arbitrary amount over an arbitrary period of time. In all cases, the Fed is affecting the money supply, they are affecting prices, they are affecting interest rates, and more importantly they are affecting relative spending, relative prices, and relative interest rates. This can be understood by utilizing the most basic of economic laws, from the law of marginal utility to the quantity theory of money to other necessary truths about action as such.

    You can’t mix oil and water and expect a permanent aqueous solution.

    You can’t mix violence and peace and expect stability.

    You can’t mix government intervention and laissez faire.

    It is also interesting to note that Sumner just admitted inadvertently that the “long and variable lag” theory is accurate. Oopsy.

  18. Gravatar of Major.Freedom Major.Freedom
    3. August 2017 at 09:42

    “The Fed does to play by market rules”

    Should read

    “The Fed does not play by market rules”

  19. Gravatar of TravisV TravisV
    3. August 2017 at 14:34

    Terrible video: “The Coming War between Trump & The Fed”

  20. Gravatar of Benjamin Cole Benjamin Cole
    3. August 2017 at 16:42

    Here is one orthodox macroeconomists will ignore:

    The world’s freest economy (as ranked by Heritage Foundation)?

    Hong Kong!

    A place where two-thirds of median family income is absorbed by mortgage payments and which has the world’s least affordable housing?

    Hong Kong!

  21. Gravatar of Ray Lopez Ray Lopez
    3. August 2017 at 21:02

    Hay Zeus Christos, did Sumner just run up the white flag and concede money is largely short term neutral? Sure seems that way. To quote the late, great, Walter White: “I win”.

  22. Gravatar of Benjamin Cole Benjamin Cole
    4. August 2017 at 01:31

    Nikkei Asian Review, today

    August 4, 2017 9:08 am JST
    Will higher wages kick-start Japan’s economic engine?
    Companies raise pay in a tighter labor market, offering escape from deflation

    TOKYO — As the Japanese economy continues to recover, driven by solid overseas demand, a labor shortage is becoming acute, presenting both challenges and opportunities for domestic companies.

    Many Japanese companies are seeing better financial results, thanks to increased sales abroad, and are boosting capital investment at home in response.


    This is how you do it.

    Haruhiko Kuroda, the world’s best central banker….

  23. Gravatar of mpowell mpowell
    4. August 2017 at 06:47

    I tend to agree with Jerry. Driving down the freeway, I think most people would say I control the steering wheel, but the constraints have a lot of similarity to a central bank’s control over interest rates.

    But don’t think I’ve missed the point of the post! I just think it is a category error to say all of this proves that central banks don’t actually control interest rates. In the common language use of the term they do. And I think it can be dangerous rhetorically to try to structure arguments this way.

  24. Gravatar of ssumner ssumner
    4. August 2017 at 10:19

    Ray, ????????????

    mpowell, See my next post.

  25. Gravatar of ssumner ssumner
    5. August 2017 at 21:05

    Jerry, When I taught at Bentley I had “control” over the number of students in my class—there were more than I wanted I could pull out a gun and shoot some of them. That’s your view. My view is that the registrar had control over the number of students in my class.

  26. Gravatar of Jerry Brown Jerry Brown
    6. August 2017 at 09:38

    Jeez Scott- how many times did you shoot the students? Glad I wasn’t in your class- sounds like a real tough course. Did you find you could improve the student evaluations if you were holding a gun in your hand?

    Now that you’re way over there on the other side of the country, I feel much safer mentioning that you always controlled the number of students in your class. Because you could just quit and then there would be zero. And I bet if you could create money at will like the Fed can do, you could have paid your students to leave class or you could have attracted as many as could fit in your classroom. And then you could start shooting with no chances of missing.

  27. Gravatar of Jerry Brown Jerry Brown
    6. August 2017 at 09:49

    I guess it could be a ‘sure fire way’ to control grade inflation as well. Good thing I wasn’t an ‘A’ student in college.

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