Making Sense out of Fed Policy


By Dr. Harold A. Black

The current commentary about the Federal Reserve is almost exclusively on how it is fighting inflation. The Fed has raised its Fed Funds target range from near zero to 4.25-4.5 percent and it is this rate that the media details ad nauseum. The speculation is on how high will the Fed go. Some have predicted as high as 6 percent. Whatever the Fed will do depends on what the Fed economists think the future will look like, in particular future inflation and employment. Although the media pushes the narrative that current reports of inflation and employment are somehow predictive of what the Fed will do now, at best that narrative is misleading. Fed policy operates with a significant lag. If the Fed employs unambiguous monetary policy, the effects will not be seen for at least a year and often longer. Thus, the Fed is looking forward, not backward, contrary to the commonplace story told by the media. However, current events can give the Fed cover for its intended actions.

Consider that we are all told that the Fed sets interest rates. In reality, markets set rates. While the Fed can in the short run affect the direction where interest rates go, it does not actually set the rates. The best example is that it sets a Fed funds target rate and not the precise rate itself. Fed funds are bank excess reserves traded overnight by banks. Supply and demand for bank reserves set the rate. The Fed influences the supply of Fed funds. When it wants the rate to rise, it decreases the supply of bank reserves by selling Treasuries to the banks and taking reserves as payment. The decrease in supply raises the Fed funds rate but that increase cannot be precisely determined.

The two interest rates that the Fed can determine are the rate that the Fed pays the banks on bank reserves and the discount rate, which is the rate that the Fed charges banks that wish to borrow at the Fed’s discount window. Currently those rates are within the Fed funds target range. This is important because if the discount rate is below the Fed funds rate, the banks could borrow cheaper from the Fed which would counteract what the Fed is doing in the Fed funds market. Also, the Fed can discourage bank lending if it pays higher interest on the banks’ reserves. Why should the banks lend and incur risk when it can keep its money safely at the Fed at near the same rate?

Currently, the Fed is saying that inflation is predicted to fall this year to around 3 percent and unemployment rising to 4.6 percent. Although the Fed is not saying that the economy will go into recession, the markets are wary. However, the Treasury yield curve is downward sloping, predicting a recession. The yield curve plots interest rates on Treasuries over time by maturity. Usually, the 3 month Treasury bill yields are below that of longer term bonds. However, for the past months the curve is inverted with shorter term yields being greater than longer term ones. This means that the market is reluctant to invest longer term due to uncertainty.

Nevertheless, what business reporting fails to mention is that inflation is always a monetary phenomenon. The Fed is responsible for the current inflation by enabling the massive increase in Federal spending by increasing the money supply when it grew its balance sheet from $1 trillion to $8.5 trillion. Now it is trying to shrink the money supply by decreasing the amount of banks’ excess reserves, which create money when loaned out. No business correspondent mentions this and most business reports would probably earn at best a “C” if submitted as an economics paper.

When the Fed countered the great recession of 2008, it dramatically lowered the Fed funds rate and eventually pushed it to near zero. Even though these actions may have had some merit, the only reason that the Fed kept rates low was for political, not economic, reasons. As is always the case, the Fed’s conduct is the primary cause of economic uncertainty and market volatility. Although most of the media seem to think that rising interest rates foretell gloom, there is one positive note. My sainted mother used to ask me during the zero Fed rate era, “Why does the Fed hate seniors?” Of course, she was correct because her CDs earned virtually no interest return.  Well at least now, even though the Fed may still hate seniors, the pain it is inflicting is a bit less.