Tuesday, September 29, 2015

Not setting the interest rate


From the FRED Blog:
The traditional policy tool of the Fed is to target the federal funds rate. Note the term target. Indeed, the Fed does not set this interest rate; rather, it sets the target and then conducts open market operations so that the overnight interest rate on funds deposited by banks at the Fed reaches that target.

The Fed does not set the interest rate. It sets the target and conducts open market operations so that the interest rate reaches this target.

10 comments:

Greg said...

They do set the FFR, thats the rate that everyone breathlessly awaits every Fed meeting, the one they decided not to raise a couple weeks ago although there were hints they would.

What happens to other rates as a consequence of their action is somewhat left to "the market" though. I say somewhat because if the Fed stands in as buyer (of govt bonds) at a certain price and will buy whatever quantity is made available at that price they have "set" an interest rate on those bonds.

The quote in your post is simply describing HOW interest rates (prices) are changed. As Mosler would say, the Fed is the monopoly supplier of reserves and a monopolist has two options; 1) set a price and let quantity float or 2) set a quantity and let price float. You can only choose one.

Those who want to argue that its the bond traders who set interest rates need to consider two things 1) the Fed is a bond trader too and 2) current conditions in a private trader determined bond market could only be possible if one believes that the private traders want high bond prices Turn on CNBC or Fox Business and tell me how many times you hear a trader on there saluting high bond prices. It aint happening. The market guys want higher interest rates but they cant fight the Fed. Their whole strategy is to scare the Fed with inflation stories so they will meet and raise rates. Bond traders are not altruists, they aren't "giving" the govt low rates on their debt. Low rates on debt is an inducement to borrowing, how many voices on the financial channels are arguing for the govt to borrow more?

geerussell said...

Pretty much what Greg said. That really is a weird passage... "the Fed does not set this interest rate; rather, it [insert operational description of how the Fed sets this rate without using the word set]". As a cherry on top, the description is some eight years out of date too.

The Arthurian said...

Here's how I see it. The FedFunds rate is set the same way many other prices are set -- by the interaction of supply and demand. That's what "open market operations" are, the interaction of supply and demand.

The Fed SETS A TARGET. This does not magically make the FedFunds rate move to the target level. In other words, the Fed sets the TARGET, not the RATE.

Then the Fed uses the supply and demand for Fed Funds to bring the rate toward the target. But it is not setting the target that makes the FedFunds rate change; it is changes to the supply of FedFunds.

Greg: "two options; 1) set a price and let quantity float or 2) set a quantity and let price float. You can only choose one."

Sure! The Fed decides on a price and then sets the quantity and lets the price float to get the price near to the target.

Note that DECIDING on a price is not the same as SETTING a price, for it is not the decision which changes the price. The Fed lets the "open market" determine the price, and the Fed adjusts the supply in response to market conditions, in order to bring the rate toward the target.

//

Note that FRED's FEDFUNDS is described as the EFFECTIVE rate, which differs or may differ from the TARGET rate.

Unrelated: Note that the graph seems to show the Fed target lagging the effective rate both on the way up and on the way down.

The Arthurian said...

Geerussell, the part of the FRED Blog post that I quoted uses the word "set" twice.

Also, as Greg observes, the FRED Blog quote DESCRIBES HOW THE FEDFUNDS RATE IS CHANGED.

Greg said...

There is a big part of this though that isn't discussed, which must be. In our system the Fed must keep the system full of reserves so that all payments clear, that is a prime part of their job. They set reserve requirements (currently 10% I believe) and they set the overnight borrowing rate (FFR). Under current conditions and most of the time the Fed has to work to keep the FFR ABOVE zero. By doing nothing and just allowing reserves to flood the system and keep the payment system working the FFR would trend towards zero.

You hear many people squawking that the Fed is keeping rates "artificially" low, when in fact they are keeping them above zero. They would plummet to zero as the supply of them overwhelmed the demand for them in the current lending environment. One way they induce banks to hold reserves is to actually pay interest on reserves, something that was begun after the crisis in 2007/8.

Of course much of this idiocy would be stopped if we didn't have a bunch of monetarists running the Fed. These people are convinced that reserves are some type of "super money" possessing these powers which make people borrow even when they have no more disposable income. Somehow they will just jump into your bank account.

The Arthurian said...

I did another graph comparing the FF "target" and the "effective" rate, this time the daily effective rate. The lag that I imagined is now gone.

https://research.stlouisfed.org/fred2/graph/?g=1Z1z

Also this, from the NOTES page of that graph:

The federal funds rate is the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight. When a depository institution has surplus balances in its reserve account, it lends to other banks in need of larger balances. In simpler terms, a bank with excess cash, which is often referred to as liquidity, will lend to another bank that needs to quickly raise liquidity. The rate that the borrowing institution pays to the lending institution is determined between the two banks; the weighted average rate for all of these types of negotiations is called the effective federal funds rate. The effective federal funds rate is essentially determined by the market but is influenced by the Federal Reserve through open market operations to reach the federal funds rate target.

The Arthurian said...

"The effective federal funds rate is essentially determined by the market but is influenced by the Federal Reserve through open market operations to reach the federal funds rate target."

Greg said...

To me the main point of this argument about whether its "set" or if its "targeted" is whether or not 1)the Fed (an arm of the govt) or 2) the bond traders (the market/private sector) run the show.

Those who worry about bond vigilantes stepping up and denying the US govt access to the bond market (meaning the govt wouldn't have any money to spend) are firmly in the 2) camp. Reality is in the 1) camp. The mechanisms by which the fed reaches its target, while interesting and full of profit opportunities for some players, don't change the fact that the Fed gets to say where these interest rates will end up. They are the ONLY players in the market that have an unlimited capacity to buy bonds. No private sector trader can out bid the Fed if they don't want them to.

As I said above, the Fed IS part of the market. They are a trader. They get to bid too. Who wants to bid against them if they know the Fed wants it?

One other thing needs to be added here I think. Just because the above is all true, doesn't mean the Fed has these magic powers to "control" the macroeconomy. The problems our economy is suffering from are not remedied by a Fed with all those powers. The Scott Sumners of the world are convinced the Fed can get any NGDP it wants if it just tried hard enough and that by "setting" NGDP we can get output and employment to better places.

The Fed is powerful but they aren't all powerful.

The Arthurian said...

Perhaps I spent too much time thinking alone, Greg, but I am perfectly happy to confine a discussion of whether the Fed sets interest rates or targets them to one very small and very specific topic. And I am at a loss when a specific question becomes broadened to cover topics I have not thought about or about which I have no particular views.

To me the main point of this discussion is whether it is okay to pretend that open market operations are not needed when the Fed decides to change the interest rate.

We may be in Kansas because we decided to go to Kansas, but our decision was not what brought us to Kansas. It was our vehicle that brought us.

"The Scott Sumners of the world are convinced ... that by "setting" NGDP we can get output and employment to better places."

Well said.

Greg said...

"To me the main point of this discussion is whether it is okay to pretend that open market operations are not needed when the Fed decides to change the interest rate"

Fair enough.

It does seem though like many take OMO to be just like transactions on secondary markets, where private parties all decide what they want and what they will pay. OMO are primary market ops and they involve the Fed on one side of the "trade". The Fed has deeper pockets than anyone does. They win bidding wars they want to win.