The guest commentary below was written by Dr. Daniel Thornton of D.L. Thornton Economics.
In my first essay on the limits of monetary policy, Why Interest Rates Don’t Matter, I noted that economists have known for a long time that changes in interest rates have at best a modest effect on spending. Nevertheless, a consensus has formed around the belief that monetary policy works through interest rates, the so-called interest rate channel of monetary policy.
There is also a widespread belief among policymakers (and some economists) that their actions have a large effect on interest rates. This essay discusses why monetary policy actions should have no appreciable effect on interest rates generally and why, in spite of this fact, the Federal Open Market Committee’s (FOMC’s) changes in the federal funds rate target have an effect on mostly short-term rates.
Economic theory suggests that the Fed actions should not have a permanent effect on any interest rate—not even the federal funds rate. “Why not?” The simple answer is that the interest rate is the price of credit. Fed actions have a relatively small effect on the supply of credit, so they should have at best a tiny, most likely, imperceptible effect on interest rates.
The more complicated answer requires the concept of arbitrage. Arbitrage is the process of simultaneously purchasing an asset in one market and selling the same asset in another market. In the credit market, it is borrowing in one market and simultaneously lending in another market, or vice versa.
I’ll explain why the FOMC should not be able to control the federal funds rate with a simple thought experiment (this discussion draws heavily on my previous essay The Rain Man). Assume that there are only two markets: the federal funds market and the market for negotiable certificates of deposit (CDs). Before September 15, 2008, large banks acquired a significant amount of their funds for lending in the CD market. Assume that both markets are in “equilibrium.” The equilibrium rates need not be equal, but it is convenient to assume that they are, say 4 percent.
Now assume that the FOMC wants to reduce the federal funds rate to 3.5 percent. To do this, the Fed would purchase securities. The Fed pays for the securities by writing a check on itself. When the Fed’s check is cleared through the banking system, deposit balances of banks at Federal Reserve Banks (i.e., reserves) increase by the amount of the check. This causes banks to hold more reserves than they would like (excess reserves) which, in turn, causes the federal funds rate to decline. Now assume that the Fed’s purchases caused the federal funds rate to decline to 3.5 percent.
“The Fed has achieved its objective, right?” No.
The problem is that the federal funds market and the CD market are no longer in equilibrium—the federal funds rate is 3.5 percent, but the CD rate is still 4 percent. Banks now have an incentive to finance more of their lending by borrowing in the federal funds market and less in the CD market. The increased demand for federal funds causes the funds rate to increase; the reduced demand for CDs causes the CD rate to fall.
How much the CD rate falls and how much the federal funds rate rises depends importantly on the relative size of the two markets. If the CD market is large relative to the federal funds market (which it is), the decline in the CD rate will be small relative to the rise in the federal funds rate. If the CD market is very large relative to the funds market, the CD rate would decline a few basis points and the funds rate would rise back to within a few basis points of 4 percent. In order to push the funds rate down to 3.5 percent, the Fed will have to purchase more securities. Indeed, the Fed would have to keep purchasing securities until the CD and federal funds market achieved a new equilibrium at 3.5 percent.
“At least now the Fed has permanently reduced the federal funds rate to 3.5 percent.” No, it hasn’t.
“Why not?” Because people who lend to banks in the CD market have other opportunities; they can purchase Treasury bills, commercial paper, corporate bonds, etc. With the CD rate now lower, individuals have the incentive to reduce their lending in the CD market and lend more in other markets. This will cause the CD rate to rise and rates in other markets to fall. With the CD rate again higher than the funds rate, banks will borrow more in the federal funds market and less in the CD market. Hence, the Fed will have to purchase still more securities. The Fed would have to purchase whatever quantity of securities is required to achieve a new equilibrium over the entire structure of interest rates. The Fed’s purchase would have to be enormous because the credit market is enormous.
The Fed’s purchases of securities have never been large historically. The Fed has increased its contribution to the total supply or credit by over $3 trillion since September 15, 2008. But even this amount is small compared with the size of the credit market. Hence, there is little reason to believe that these purchases had a large effect on the entire structure of interest rates.
Things don’t work exactly as my thought experiment suggests because only banks, Freddie Mac and Fannie Mae, and the Federal Home Loan Banks are allowed to hold deposits with the Federal Reserve, and are the only institutions that can participate in the federal funds market (banks buy or sell funds, but the others only sell funds). Consequently, the federal funds market is segmented from the rest of the financial market by construction. Moreover, the federal funds market is small, only about $100 to $150 billion a day. Consequently, the amount of funds large banks can obtain in the federal funds market without causing the federal funds rate to be higher than the CD rate is limited.
Prior to 1991, banks were willing to pay a higher rate on funds obtained in the federal funds market because CDs were subject to a 3% reserve requirement, while funds obtained in the federal funds market were not. This is illustrated in the figure that shows the difference between the 1-month CD rate and the federal funds rate. Starting in the late 1960s, the federal funds rate would be, more often than not, higher than the CD rate. The reserve requirement on savings deposits was eliminated on December 28, 1990. With few exceptions, the CD rate was higher than the federal funds rate.
However, none of this mitigates the point of the thought experiment. Specifically, the effect of the Fed’s actions on interest rates should be determined by the Fed’s contribution to the total supply of credit. The bottom line is the same: The Fed cannot have any appreciable effect on interest rates generally unless the FOMC is willing to engage in massive assets purchases; purchases well beyond anything that it has done to date.
'Open Mouth Operations'
“Ok, but it appears that the FOMC controlled the federal funds rate very well prior to Lehman’s announcement.” Yes, and this makes a difference. But the FOMC didn’t do it. The market did it. Specifically, the funds rate moved to the new target and stayed there until the FOMC announced a new target. This happened because market participants believed that the Fed could and would enforce the new target. This effect is called open mouth operations—the FOMC merely announces a new target and the funds rate goes there. As difficult as it might be to believe, this is what happens.
Why? Well, it’s complicated. But it is due in large part to the fact that, unlike cell phones, cars, and other physical goods, the production cost of credit is tiny. Hence, the credit market uses other information to set interest rates. The Fed has been historically seen as an institution whose actions have a large effect on interest rates for a variety of reasons—not the least of which is the Fed’s apparent success in pegging the 3-month Treasury bill rate at 38 basis points from July 1942 to June 1947. Consequently, short-term interest rates tend to move when the FOMC announces changes in its target for the funds rate. Indeed, short-term rates tend to key off of the federal funds rate. (see The Rain Man for more details).
There is one more reason why many economists and most policymakers believe the Fed can affect interest rates. Specifically, they believe the Fed can affect interest rates because longer-term interest rates are determined by the expectations hypothesis of the term structure of interest rates (EH). The EH asserts that long-term rates are determined by market participants’ expectation of the short-term rate and, hence, the federal funds rate. Thus, longer-term rates can be changed by changing the target for the funds rate and by signaling future changes in the funds rate.
I have written a thorough discussion of why the EH doesn’t work in a chapter of the Oxford Handbook on the Economics of Central Banking (forthcoming). Here is a very short synopsis of why the EH doesn’t work. First, the EH is not a theory. It is an intertemporal arbitrage requirement. Indeed, I show that if each market participant priced long-term bonds on their expectation of the federal funds rate, the EH depends on an unknown and unspecified aggregator function—the EH is not a well-specified theory. Second, short-term interest rates, including the funds rate, are essentially unpredictable. It’s hard to believe that a rational investor would price a 10- year bond on their expectation of a short-term interest rate that they know they cannot predict with any reasonable degree of accuracy.
The Fed’s so-called forward guide, which the Fed began in December 2008 and abandoned in March 2014, was an attempt to make the funds rate more predictable. But Kool & Thornton, 2015 shows that it was not successful. But this is hardly surprising given its virtually non-existent theoretical foundations and the unpredictability of shortterm rates (see “Predictions of Short-Term Rates and the EH,” Guidolin and Thornton 2017, available upon request). Indeed, the EH has been massively rejected in a large number of empirical studies over different sample periods, using a variety of long-term and short-term interests rates and alternative monetary policy operating procedures.
Yet some analysts are surprised that long-term rates are slightly lower in spite of the fact that the FOMC increased its funds rate target a full percentage point since late 2015 and signaled that there will be further increases. Caution: This does not mean that expectations are not important for economic decision making. But the effect of current and expected future economic fundamentals domestic and foreign (e.g., inflation, economic growth, etc.) swamp the current and expected future funds rate in determining long-term interest rates. Expectations just don’t matter in the simple, mechanical way required by the EH.
Because of the FOMC’s ability to control the funds rate through open mouth operations, I show in Greenspan’s Conundrum and the Fed’s Ability to Affect Long-Term Yields and in Clarification of the Effect of Policy on Yields that the FOMC’s zero interest rate policy affected Treasury rates across the term structure. However, the effect weakens as the term to maturity lengthens—it is strong for maturities out to 6 months but weakens considerably as the maturity of the security lengthens beyond one year. Furthermore, the effect on long-term rates was strong only during periods when the funds rate was exceptionally low and was temporary.
The conclusion from my first two essays on the limits of monetary policy is this: interest rates matter little for spending and the Fed has little effect on longer-term interest rates that should matter most for spending. Consequently, the FOMC’s actions on the federal funds rate have little or no meaningful effect on spending, output, or employment. Interest rates don’t matter! My third essay will address the issue of whether monetary policy can affect economic growth, independent of the question of whether monetary policy works through the interest rate channel—independent of whether or not interest rates matter.
EDITOR'S NOTE
This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.
