Fed Policy: Chicken or Egg?

When it comes to chickens & eggs or climate change & Al Gore, we don’t know which came first. We take this to mean that we don’t know what is the ultimate cause of these things though I suspect Al Gore came from another planet. Regardless, the topic today is the Federal Reserve or as we lovingly call it – the Fed. The Fed says they will keep interest rates low. I doubt they can do it. 

There is a widely shared belief that the Fed controls interest rates. Thus we could say that the Fed causes interest rates and not vice versa. When Ms. Yellen proclaims that interest rates will remain low until Clint Eastwood stops making movies, that gives us the illusion that the Fed can and will keep rates low for a very long time. But this illusion, while technically correct, for most purposes can be highly misleading. This post suggests that interest rates will begin to rise soon, with or without the Fed’s permission.

To understand this point we have to go back and read several tons of text books or you can wake up and just read the next few paragraphs. Like there are many different kinds of Kentucky bourbons, there are many different interest rates. An interest rate tastes like chicken. No it doesn’t. An interest rate tells you how much you earn on a financial instrument. If you put money into a bank saving account your money would be earning about .02%. Invest your money in a government bond that matures in 30 years and you might get 3.5%. Corporate bonds might give you a little higher rate. These rates are market determined. That means that while a Fed policy might influence these rates, the Fed has no direct control over them. The buying and selling of these financial instruments by individuals and institutions change the prices and rates every day.

The one rate the Fed does have almost total control over is called the Federal Funds Rate (FFR). I say “almost” because even that rate is not dialed up or down in a mechanical fashion by the Fed. The FFR is mostly affected by banks borrowing money from each other. On a day when many banks want to borrow the rate goes up. When many banks don’t want to borrow from each other, the rate goes down. But unlike the other rates I mentioned above, the Fed considers the FFR as a target of monetary policy. When the Fed swears on a stack of Tim Geithner novels to keep interest rates at zero – we take this very seriously. We wait from Fed meeting to Fed meeting to learn of any real or imagined changes in the value of the Fed’s goal for the FFR.

It is easy for the Fed to control this rate. If bankers want to borrow a ton of money from each other on Tuesday then the FFR starts rising. The Fed watches and Yellen says – geez guys. I promised the FFR will stay at zero and today the rate is rising. So Janet knows what to do. She pumps money into the system so banks have plenty of money. They don’t need to borrow from other banks – the Fed intervenes and gives it to them. The FFR rate goes back down to zero. Like water on a fire, when the fire rares up just pour on more water.  The Fed apparently controls the FFR. 

But does it? Technically it does. It can do the actions of the last paragraph forever since the Fed has permission from the Koch brothers to increase money at will. No digging up gold is necessary. But the trick here is whether or not they can make their policy stick. You can pour water on a fire but if it a grease fire it might actually make the fire worse. In the case of the Fed policy, the focus is on the market factors responsible for driving up the FFR. Perhaps the FFR is just following other market-determined interest rates. Suppose the economy is stronger and inflation expectations are rising. These are factors that usually drive up market rates, including the FFR.

If markets are driving up interest rates then a one-time injection of money will take the FFR back down to zero. But will it stick? If the economy and its inflation rate are rising, then there will be continuous pressure on the FFR to rise. You might say that is no big deal because the Fed can just pump in more money. But here’s the challenge. If each time the Fed pumps in money this stimulates output, inflation, and credit demand, then there is EVEN MORE pressure on rates to rise…here is a very technical schematic:

      Rates rise – Fed pumps – rates fall – expectations rise – rates rise even more.

At this point the best way for the Fed to keep rates from rising is to stop pumping in more money. When people start to recognize that the Fed will stop stimulating the economy then they will reduce their expectations about economic strength and inflation. This reduced expectation brings rates back down.

So who controls interest rates in the economy? The answer is that it depends. If rates are being strongly driven by economic fundamentals it is not easy for the Fed to have much sway. They will have a very difficult time stopping rates from rising and attempts to do so may make matters even worse. Of course if the economy is not thrusting rates higher, this gives the Fed more room to maneuver. But if that is the case, it isn’t clear why the Fed would want to reduce rates. The market is already doing that trick. 

To modern progressives, this sounds strange and it should. Monetary activists think the Fed is all-powerful and should regularly employ countercyclical policy. But not everyone is a monetary activist. Milton Friedman and other monetarists have warned for decades about the unintended consequences of monetary activism. Today we have a very activist Fed under the guidance of Janet Yellen – a Fed that will promise lower future interest rates despite an inability to bring out that result. Bet on higher rates in the coming 6-12 months.