About a month ago JW Mason of The Slack Wire asked, Does the Fed Control Interest Rates? This was in response to some back-and-forth regarding the effectiveness of monetary policy. Previously on this blog, I’ve outlined my view that interest rates are determined by expectations about the future path of monetary policy (see here, here and here). In this sense, the Fed does, to varying degrees, control interest rates across the curve. Mason attempts to dispel that view, in part, with the following chart showing the rate structure against moves in the Fed Funds rate:
His conclusion is:
Wouldn't it be simpler to allow that maybe long rates are not, after all, set as "the sum of (a) an average of present and future short-term rates and (b) [relatively stable] term and risk premia," but that they follow their own independent course, set by conventional beliefs that the central bank can only shift slowly, unreliably and against considerable resistance? That's what Keynes thought.
So apparently the Fed doesn’t control interest rates. Well, hold on a moment. Not long after Mason’s post, The New Arthurian Economics responded with But why, JW? Why "The past 25 years"?? As you’ll note, the above chart only considers rates back to 1987. Using some clever data mining and chart altering, Art comes up with the following historical look at the Fed Funds rate versus an average of other market interest rates:
Once again, it appears that rates are not following the Fed as closely as one might expect.
Responding to both Mason and Art, in the comments, I offered my own answer to the question. In short (you can read the full comments if you choose), market expectations of future Fed action are sticky. During the post-war period until about 1980, inflation was consistently rising despite mainstream economic views that suggested those conditions would not persist. Following a lengthy inter-war period of near rock-bottom interest rates, market participants were slow to adjust expectations to the actual height of interest rates that would occur before sustained disinflation began. Once disinflation began in the early 1980’s, market expectations were equally slow in recognizing how long disinflation could persist and therefore how low the Fed would ultimately take rates (and hold at zero).
Contrary to this expectations based view, Jazzbumpa, of Angry Bear, countered with a link to his previous post on Who Determines Short Term Interest Rates? His conclusion, supported by various graphs:
The Federal Funds Rate, which is set by the Fed, FOLLOWS 3 month T-Bill rates. It does not lead the economy.
This leads to two important questions on the subject:
1) Does the Fed have any real power to influence interest rates?2) What would happen if they attempted to move counter to the market?
These questions have plagued me for the past few weeks, but I think I’ve found the answer.
As I pointed out in one my comments:
The Fed acts in certain intervals and operates under a corridor system. In this manner, the Fed sets the target rate but permits fluctuations within a band between the discount rate and IOR rate.
Now let’s imagine that during an interval between FOMC meetings, private credit expansion is causing banks to demand more reserves. Absent open market operations that increase the supply of reserves, the Fed Funds rate will move higher towards the upper bound of the targeted range. Witnessing this change, the Fed can choose to respond by either expanding the supply of reserves to maintain its current policy rate or by raising the rate to match the “market-determined” interest rate. The same principle would apply in reverse to a decline in demand for reserves. In this manner, the Fed FOLLOWS the market in supplying reserves and setting the Fed Funds rate.
Not surprisingly, the story above complements the paper by Scott Fullwiler “Interest Rates and Fiscal Sustainability”, which notes:
“More recently, Fullwiler (2003) and Lavoie (2005) have demonstrated that the central bank’s obligation to promote the smooth operation of the payments system means that the provision of reserve balances are necessarily non-discretionary. (p.12)”
After much thought, I’m willing to concede that the Fed primarily acts (or has acted) passively in setting short-term rates. This view, however, does not entirely undermine the expectations theory for long-term interest rates or the Fed’s ability to control interest rates. If market participants are aware that the Fed reacts to market moves, then future expectations regarding a “market-determined” interest rate provides a reasonable proxy for the Fed Funds rate. Separately, the Fed could announce a ceiling on long-term Treasury rates and dare the market to test its resolve. Therefore, I accept that in practice the market determines interest rates, but retain the view that operationally the Fed could control interest rates.
A real test of the Fed’s power to manipulate interest rates would require the Fed to either act counter to the market or cap specific rates along the curve. Although the latter seems more likely than the former, I don't expect either action to occur anytime in the near future. Considering central banks outside of the Fed, the ECB may soon provide a real-world experiment by setting a ceiling on rates. Though the EMU holds stark differences with the US monetary system, it will be enlightening to witness a central bank truly take on the markets. This debate is far from over...
Arjun Jayadev notes that:
A common story holds that the key cause of the financial turmoil in the U.S over the last two decades was the excessively low interest rates. This perspective lays the blame for the financial crisis at the feet of discretionary Federal Reserve policy, and is typically made based on the fact that short term rates such as the federal funds rate or Treasury bill rates had been lower between 2001 and 2011 than in any previous decade. In short, this view claims that rates were “too low for too long.”
Trying to verify this story:
In ongoing work, Josh Mason and I look at actual interest payments to calculate the effective inflation adjusted interest rate on debt for households and for non-financial corporations. We find that the inflation-adjusted effective interest rates for households and non-financial corporations are nowhere near their historic lows during the early 2000s. While the rates are lower than anytime since the 1980s, interest rates were as low during the long period from 1950 to 1970 and certainly in the high inflation period of the 1970s.
Which is accompanied by the following graph:
These findings are actually reflected in data on the real changes in household debt per year:
From this graph we see that household debt grew at the fastest pace in the early 1950’s, when effective interest rates were lowest, then slowed through the 1970’s reaching a local low in the early 1980’s, when effective rates were highest. As rates steadily declined from there, debt growth remained positive until the start of the crisis in 2009.
While these findings appear to invalidate the “common story” told above, it leaves questions regarding my own story of the Great Recession. In my story, households (and the private sector generally) accumulated increasing levels of debt compared to income. Interest costs on this debt transferred purchasing power away from the productive sectors (household and private non-financial) to the non-productive sector (financial), which ultimately resulted in a decline of aggregate demand. The above charts show previous periods of comparable increasing debt, so why was this time different?
Since debt was apparently not growing at excessive rates, let’s consider the other half of the equation...income:
Although it’s a bit tough to discern from the above chart, average real disposable personal income has been declining every decade since the series began in 1960. (The 1960’s saw average growth of 4.5%, while the 2000’s witnessed only 2.4% growth). The consistent decline in earnings growth provides a good explanation of why, despite similar rates of debt expansion, household debt-to-GDP looks like this:
The first substantial rise (~1950-1965) in this ratio appears to have been driven by increased borrowing due to low effective interest rates, while the second massive upswing (~1983-2009) was seemingly driven by decreasing effective interest rates combined with weak income growth.
The above chart also helps explain why this time was different with regards to interest costs. Jayadev and Mason’s findings above only highlights the effective interest rate on each dollar of household debt. To understand the true burden of interest costs at the onset of the crisis, we must consider the total interest cost on accumulated debt. Since total household debt is still a much greater percentage of income, and effective interest rates are not significantly lower, the real burden of that debt is much higher.
Based on this data, it seems reasonable to conclude that low interest rates were not the primary culprit in the financial crisis. A more important area of research may be understanding why debt growth was not slowed by the decline in incomes. This preliminary review suggests that low incomes, not low interest rates, played a greater role in the crisis.
Early in the week, global stock markets were falling fast as Spanish yields surged higher across the curve. Fearing that markets would quickly spiral out of hand, Jon Hilsenrath (WSJ) stemmed the tide by signaling forthcoming action from the Federal Reserve next week. Not to be outdone by his US counterpart, the ECB’s Mario Draghi provided a bazooka of open mouth operations by stating:
"The ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough"
As Bruce Krasting points out, this is not the first time an EU politician has proclaimed an end to the crisis. While details of Draghi’s plan remain largely unknown (and undecided?), even his best efforts will do little to spur economic growth. Spain is suffering from excessive private debt, a bursting housing bubble and as Krasting notes:
its competitiveness. The domestic economy will never recover without a currency devaluation (and debt restructuring). If Mario has his way, Spain will suffer from a decade of recessions with unemployment over 20%. How could he possibly call that outcome a success?
The answer to that question is actually quite simple and was given by JW Mason in a post titled Pain Is the Agenda: The Method in the ECB's Madness:
Here's an editorial in the FT on the occasion of last summer's ECB intervention to support the market for Italy's public debt:
Structural reform is the quid pro quo for the European Central Bank’s purchases last week of Italian government bonds, an action that bought Italy breathing space by driving down yields. ... As the government belatedly recognises, boosting Italy’s growth prospects requires a liberalisation of rigid labour markets and a bracing dose of competition in the economy’s sheltered service sectors. This is where the unions and professional bodies must play their part. Susanna Camusso, leader of the CGIL, Italy’s biggest trade union, is threatening to call a general strike to block the proposed labour law reforms. She would be better advised to co-operate with the government and employers... The government’s austerity measures are sure to curtail economic growth in the short run. Only if long overdue structural reforms take root will the pain be worthwhile.
A couple of things worth noting here. First the explicit language of the quid pro quo -- the ECB was not just doing what was needed to stabilize the Italian bond market, but offering stabilization as a bargaining chip in order to achieve its other goals. If ECB was selling expansionary policy last year, why be surprised they're not giving it away for free today? Note also the suggestion that a sacrifice of short-term output is potentially worthwhile -- this isn't some flimflam about expansionary austerity, but an acknowledgement that expansion is being give up to achieve some other goal. And third, that other goal: Everything mentioned is labor market reform, it's all about concessions by labor (including professionals). No mention of more efficient public services, better regulation of the financial system, or anything like that.
The FT editorialist is accurately presenting the ECB's view. My old teacher Jerry Epstein has a good summary at TripleCrisis of the conditions for intervention; among other things, the ECB demanded "full liberalisation of local public services…. particularly… the provision of local services through large scale privatizations”; "reform [of] the collective wage bargaining system ... to tailor wages and working conditions to firms’ specific needs...”; "thorough review of the rules regulating the hiring and dismissal of employees”; and cuts to private as well as public pensions, "making more stringent the eligibility criteria for seniority pensions" and raising the retirement age of women in the private sector. Privatization, weaker unions, more employer control over hiring and firing, skimpier pensions. This is well beyond what we normally think of as the remit of a central bank.
So what Krugman presents as a vague, speculative story about the ECB's motives -- that they want to hold politicians' feet to the fire -- is, on the contrary, exactly what they say they are doing.
It's true that the conditions imposed by the ECB on Italy and Greece were in the context of programs relating specifically to those countries' public debt, while here we are talking about a rate cut. But there's no fundamental difference -- cutting rates and buying bonds are two ways of describing the same basic policy. If there's conditions for one, we should expect conditions for the other, and in fact we find the same "quid pro quo" language is being used now as then.
Here's a banker in the FT:
The future of Europe will therefore be determined by the interests of the ECB. Self-preservation suggests that it will prevent complete collapse. If necessary, it will overrule Germany to do this, as the longer-term refinancing operations and government bond purchase programme suggest. But self-preservation and preventing collapse do not amount to genuine cyclical relief and policy stimulus. Indeed, the ECB appears to believe that in addition to price stability it has a mandate to impose structural reform. To this extent, cyclical pain is part of its agenda.
Again, there's nothing irrational about this. If you really believe that structural reform is vital, and that democratic governments won't carry it out except under the pressure of a crisis, then what would be irrational would be to relieve the crisis before the reforms are carried out. In this context, an "irrational" moralism can be an advantage. While one can take a hard line in negotiations and still be ready to blink if the costs of non-agreement get too high, it's best if the other side believes that you'll blow it all up if you don't get what you want. Fiat justitia et pereat mundus, says Martin Wolf, is a dangerous motto. Yes; but it's a strong negotiating position.
The whole post is well-worth reading, but these comments say it all. By working to prevent an all out collapse of the EMU, Draghi is merely taking the necessary actions to maintain his position. If Spain or other European countries must “suffer from a decade of recessions with unemployment over 20%” in order to implement the desired structural reforms than so be it. Whether or not that outcome is politically feasible remains an open question, but I have my doubts. Draghi was not the first to claim “it will be enough" and won’t be the last to make that claim either.
Casey Mulligan recently offended a significant portion of the economics blogosphere by stating that:
New research confirms that the Federal Reserve’s monetary policy has little effect on a number of financial markets, let alone the wider economy. Politicians, and a few economists, have been imploring the Federal Reserve to help the economy grow before November. But the effects of monetary policy on the wider economy are small.
Although I have repeatedly attempted to show that, under current conditions, monetary policy would be largely ineffective at stimulating the broader economy, this should not be taken as a dismissal of the general potential for monetary policy. Cullen Roche chimes in on the subject with a conclusion that sums up my views:
monetary policy has been very weak in the current environment for several reasons. The primary reason is due to a lack of demand for debt. Consumers are saddled with excessive debt so demand for “inside money” has been abnormally weak in recent years. This is perfectly normal following a credit driven bubble. And since monetary policy primarily works through altering the cost of “inside money” it’s not surprising that the actions of the Fed have appeared rather ineffective in recent years. But this unusual environment should not be taken to mean that the Fed has zero options or that monetary policy is never effective. To do so would be a vast misunderstanding of the basics of banking and the way our monetary system works. Monetary policy might be a blunt instrument at times, but let’s not make extreme comments that sound ideological or take the uniqueness of today’s environment to make sweeping generalizations.
Beyond this main issue concerning the effectiveness of monetary policy, Mulligan’s post raised the question of whether the Federal Reserve controls long-term interest rates. Since the Federal Reserve could purchase all outstanding Treasuries at a given price/yield, I think it’s fair to say the potential power for strict control exists. A more basic question, however, is whether past and current policy displays control over long-term Treasury rates. I’ve argued affirmatively, drawing on comments from Edward Harrison, Gary Becker and others, that long-term Treasury rates are primarily a function of expected short-term rates over a given period. JW Mason, whose work I highly regard, disputes this claim:
it's not at all obvious that long rates follow expected short rates either. Here's another figure. This one shows the spreads between the 10-Year Treasury and the Baa corporate bond rates, respectively, and the (geometric) average Fed Funds rate over the following 10 years.
If DeLong were right that "the long government bond rate is made up of the sum of (a) an average of present and future short-term rates and (b) term and risk premia" then the blue bars should be roughly constant at zero, or slightly above it. [2] Not what we see at all. It certainly looks as though the markets have been systematically overestimating the future level of the Federal Funds rate for decades now. But hey, who are you going to believe, the efficient markets theory or your lying eyes?
From my perspective, this preliminary conclusion from Mason confuses expected average rates with actual outcomes. Although I can’t speak for DeLong (or others), the notion that markets might/have systematically overestimated and underestimated future Fed Funds rates does not undermine the theory. As the following chart shows, inflation and 10-year Treasury rates were primarily rising from the early 1960’s until the early 1980’s. Based on economic theory at the time (e.g. Phillips curve), it was not unreasonable to expect that inflation would subside with increasing unemployment and the Federal Reserve would lower rates in response. The unexpected persistence of inflation likely caused many investors to consistently underestimate future Fed Funds rates during this period.
By the time Paul Volcker took over as Chairman of the Federal Reserve, many (most) investors had probably come to expect persistent inflation. When inflation crashed in the early 1980’s, it would have been equally reasonable to expect a return to high inflation and Fed Funds rates. The actual outcome has been largely subdued inflation, now going on 30 years. To understand how unexpected this outcome was, one only has to consider that returns on long-term Treasuries has exceeded returns on stocks during this 30-year period (a previously unthinkable feat missed by nearly all investors).
Mason continues his post with the counter claim that:
What profit-maximizing bond traders do, is set long rates equal to the expected future value of long rates.
I went through this in that other post, but let's do it again. Take a long bond -- we'll call it a perpetuity to keep the math simple, but the basic argument applies to any reasonably long bond. Say it has a coupon (annual payment) of $40 per year. If that bond is currently trading at $1000, that implies an interest rate of 4 percent. Meanwhile, suppose the current short rate is 2 percent, and you expect that short rate to be maintained indefinitely. Then the long bond is a good deal -- you'll want to buy it. And as you and people like you buy long bonds, their price will rise. It will keep rising until it reaches $2000, at which point the long interest rate is 2 percent, meaning that the expected return on holding the long bond and rolling over short bonds is identical, so there's no incentive to trade one for the other. This is the arbitrage that is supposed to keep long rates equal to the expected future value of short rates. If bond traders don't behave this way, they are missing out on profitable trades, right?
Not necessarily. Suppose the situation is as described above -- 4 percent long rate, 2 percent short rate which you expect to continue indefinitely. So buying a long bond is a no-brainer, right? But suppose you also believe that the normal or usual long rate is 5 percent, and that it is likely to return to that level soon. Maybe you think other market participants have different expectations of short rates, maybe you think other market participants are irrational, maybe you think... something else, which we'll come back to in a second. For whatever reason, you think that short rates will be 2 percent forever, but that long rates, currently 4 percent, might well rise back to 5 percent. If that happens, the long bond currently trading for $1000 will fall in price to $800. (Remember, the coupon is fixed at $40, and 5% = 40/800.) You definitely don't want to be holding a long bond when that happens. That would be a capital loss of 20 percent. Of course every year that you hold short bonds rather than buying the long bond at its current price of $1000, you're missing out on $20 of interest; but if you think there's even a moderate chance of the long bond falling in value by $200, giving up $20 of interest to avoid that risk might not look like a bad deal.
Once again, I think this example confuses some aspects of bond trading. While Mason considers a bond in perpetuity, let’s instead consider a 10-year Treasury with a 4% yield and 2% Fed Funds rate expected to continue indefinitely. Now assume that this expectation for the Fed Funds rate holds true. Entering year ten, if prices don’t adjust, investors will have the option of purchasing notes with equal maturities (the 10-year Treasury only has a year remaining before maturity) that offer either a 2% or 4% yield. Given the option, investors will purchase the 4% note, pushing the price up and yield down until it reaches approximately 2%. Even if 10-year Treasury rates are still 4% at that time, the previously held bond no longer has a long-term maturity and becomes the equivalent of a short-term note/bill. This is why the expected short term rates, and not long-term rates, matter for controlling long-term Treasury rates.
Despite our differences in opinion over influencing long-term Treasury rates, Mason and I agree that:
for policy to affect long rates, it must include (or be believed to include) a substantial permanent component, so stabilizing the economy this way will involve a secular drift in interest rates -- upward in an economy facing inflation, downward in one facing unemployment. (As Steve Randy Waldman recently noted, Michal Kalecki pointed this out long ago.)
Currently, unemployment and disinflation are persisting far longer than most economists, politicians and investors expected. These outcomes have led the Federal Reserve to maintain a zero percent Federal Funds rate for three years and predict continuation of that policy for at least a couple more. As investors become increasingly convinced that short-term rates will remain at or near zero indefinitely, long-term Treasury rates have continued the secular drift lower that began in the early 1980’s.
So yes, the Federal Reserve can control long-term Treasury rates and has been doing so by adjusting market perceptions of future Fed Funds rates. Unfortunately, as Mason says:
adjusting expectations in this way is too slow to be practical for countercyclical policy.
Monetary policy, in a future crisis, will once again have its time to shine. For now, fiscal policy must take center stage to reduce household debt burdens and counteract previous measures aimed at inducing a credit bubble.
