Relevant Books
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By Milton Friedman What kind of gobbledygook is this? How can the Fed “cut interest rates” by a mere pronouncement. Sounds like King Canute commanding the tide to stop coming in. What the Fed actually did was vote to lower its target for the federal funds rate from 6% to 5.5%. The federal funds rate is the interest rate that banks pay one another to borrow federal funds overnight. Federal funds consists of the currency in circulation plus deposits at the Federal Reserve-the non-interest bearing obligations of the United States. Total federal funds constitute the monetary base. The federal funds rate is a very limited rate - it refers only to overnight loans, only between banks, and only of federal funds. Two basic questions:
1. How does the Fed influence
the federal funds rate? By buying or selling securities on the open
market.
2. How does controlling the federal funds rate have the far-reaching effects attributed to it? By adding or subtracting from the liquidity of banks, changes in federal funds lead to multiplied changes in the broader quantity of money which includes deposits in banks and saving institutions. Changes in the quantity of money in turn affect the amount of spending for consumption and investment. Changes in spending take the form of changes in prices and output in proportions depending on the availability of labor and other resources and on a host of institutional factors. In and of itself a change in the target interest rate has no effect. It has an effect only through the open market operations undertaken to influence the federal funds rate and the changes these produce in the quantity of money. For example, in the two months prior to the reduction in the target rate from 6.5 to 6.0 on January 3, 2001, M2 rose at the annual rate of 7.26%. In January, the month after the change, M2 rose at the annual rate of 12.4% - both rates that if long continued would guarantee a substantial jump in the rate of inflation FAQ’S 1. Given the Fed’s ability to influence the federal fund rate, why doesn’t the fed simply set its target at a low level – say 2% - and just keep it there? In order to carry out such a policy beginning with a situation in which the federal funds rate is 5.5%, the Fed would have to engage in large scale open market purchases. That would set in motion a rapid increase in the quantity of money, which, in turn would lead to a rapid increase in total spending, and after an interval, inflation. The demand for loans, including for federal funds, would zoom. Upward pressure on the federal funds rate would mean that the Fed would have to engage in larger and larger purchases to keep the federal funds rate at @%. The result would be hyperinflation. What this hypothetical example indicates is that while the Fed can at any time influence the federal funds rate, it cannot set it wherever it wishes without unacceptable results. If it could, the federal funds rate would never have been over 19% in some months of 1981. The range within which the Fed can influence the federal funds rate depends on past inflation and economic growth, current economic conditions, and expectations for the future. As circumstances change that range changes. AS a result, a constant federal funds target is not a neutral monetary policy. The Fed often seems to be following the market rather than controlling it. For example, the three month Treasury bill rate average 6.2% the first week of November, 2000; 5.4% the first week of January when the Fed reduced its target rate by another half of a percentage point. Was the Fed reacting to the market – or – the market to what it expected the Fed to do? No way of telling. 2. Economists talk about a “real interest rate”. What is that? The interest rate adjusted for inflation. Suppose you lend $100 for a year at 5% interest, so at the end of the year you would receive $105. If prices have risen 3% during the year, the $105 will buy only as much as $102 would have purchased a year earlier. You have realized a real interest rate of 2%. High nominal interest rates (like the 19% federal funds rate in 1981) almost always reflect high inflation. The realized real rate is only observable after the event. What matters to people making decisions is the real rate expected to prevail in the future, and that depends on estimates of future inflation. That is where the Fed plays a crucial role. By demonstrating its intentions and its ability to keep future inflation with narrow bounds, it can give investors, entrepreneurs, and savers a firm basis for forming expectations of the real interest rate that will correspond to any nominal rate. 3. Newspaper accounts tend to take it for granted that a change in the target federal funds rate affects other interest rates in the same direction – including even the rate on mortgages. Is that true? Different interest rates do tend
to move together, but the correlation is far from perfect. A change
in the Fed’s target rate has no direct effect on other rates, though it
may have an indirect effect through altering the expectations of borrowers
and lenders. More important, Fed open market purchases of government
securities to enforce a reduction in the target rate add to bank liquidity.
That increase the availability of loans, which tends to lower interest
rates across the board, particularly on short-term loans such as three-month
treasury bills, or commercial paper. However, it also tends to stimulate
the economy. That increases the demand for loans, which tends to
raise interest rates. The latter effect becomes dominant if monetary
expansion is continued at a high rate. AS a result the immediate
and long-run effects of monetary policy on interest rates generally are
in opposite directions. That is one reason why I personally believe
that targeting the monetary base – the one magnitude that the Fed does
control directly – would be a better operating procedure for a central
bank than targeting an interest rate – these days very much a minority
opinion.
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