Focus on funds rate
Financial journalists usually focus on the federal (fed) funds rate. This is the rate banks charge each other for overnight loans. The Fed has a target for the fed funds rate as part of its monetary policy strategy. But the fed funds rate is not an instrument. That is, it’s not something the Fed directly controls. Rather, the Fed sets its federal funds rate target and then uses its instruments to push the federal funds rate toward its target. The federal funds rate might be thought of as a barometer for monetary policy. But it is not the substance of monetary policy. These include the discount rate, which the Fed charges for loans, and the interest rate on excess reserves, which the Fed pays to banks that keep funds in their accounts at the Fed. The discount rate usually doesn’t matter much, because banks try not to borrow from the Fed directly, given the stigma associated with discount window lending. Interest on excess reserves is another story. Especially in a floor system, which the Fed has embraced since 2008, interest on excess reserves matters. But even here the Fed does not have complete freedom. Set the interest on excess reserves too low, and banks won’t keep their funds with the Fed. Set it too high and you choke off economic activity, because banks let capital sit idle rather than investing it in productive projects. The feasible range for interest on excess reserves is determined by factors largely outside the Fed’s control.
Monetary policy affects interest rates, because changing the money supply by buying or selling assets affects yields. But, ideally, monetary policy keeps these effects to a minimum. Good monetary policy is about allocatively neutral demand stabilization, giving markets the liquidity they need to operate at full employment. If monetary policy were “about” changing interest rates, it would become something entirely different. Interest rates are prices and some of the most important ones in the economy: the prices of various capital instruments, and hence of time and risk.
We need to change the public conversation surrounding monetary policy. Talking about the Fed’s activities in terms of interest rates is easy, but deeply flawed. It is better to keep an eye on more relevant variables, like the overall size of the balance sheet. Of course, if central bankers start making crazy statements about “yield control,” as they do from time to time, we will have to talk about interest rates.It’s absolutely proper to push back against bureaucrats with minimal skin in the game who try to tinker with the yield curve. But for ordinary Fed policy, strategy, and announcements, keep your eye on money supply and demand.
Monetary policy affects interest rates, because changing the money supply by buying or selling assets affects yields. But, ideally, monetary policy keeps these effects to a minimum. Good monetary policy is about allocatively neutral demand stabilization, giving markets the liquidity they need to operate at full employment. If monetary policy were “about” changing interest rates, it would become something entirely different. Interest rates are prices and some of the most important ones in the economy: the prices of various capital instruments, and hence of time and risk.
We need to change the public conversation surrounding monetary policy. Talking about the Fed’s activities in terms of interest rates is easy, but deeply flawed. It is better to keep an eye on more relevant variables, like the overall size of the balance sheet. Of course, if central bankers start making crazy statements about “yield control,” as they do from time to time, we will have to talk about interest rates.It’s absolutely proper to push back against bureaucrats with minimal skin in the game who try to tinker with the yield curve. But for ordinary Fed policy, strategy, and announcements, keep your eye on money supply and demand.
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