Freeman

IT JUST AIN'T SO

The Fed Sets Interest Rates?

Many Complex Market Forces Determine Interest Rates

DECEMBER 01, 1999 by RICHARD H. TIMBERLAKE

Newspaper headlines across the country on July 1 provided some bad news for consumers: “Fed moves to raise interest rates.” Associated Press writer Martin Crutsinger explained:

“The Federal Reserve raised interest rates for the first time in two years.., nudging borrowing costs higher for millions of American consumers and businesses …. At the conclusion of two days of closed-door discussions, Fed policy-makers said they were increasing the target for the federal funds rate, the interest [rate] that banks charge each other on overnight loans, from 4.75 to 5 percent. The Fed said in a statement that it felt the need to be ‘especially alert to the emergence, or potential emergence, of inflationary forces that could undermine economic growth.’”

“When the economy is growing at a rate the Fed believes is too fast,” Crutsinger advised his readers, “it raises interest rates to slow spending on big-ticket items such as homes, autos and appliances.”

How It Works

Every householder and businessman can relate to an interest rate. They see it as contributing to the cost of the monthly mortgage payment and the payment owed the bank for a business loan. So everyone has some idea that the Fed occasionally cranks up its interest-rate machine, which it keeps in a crypt in the basement of the Federal Reserve Bank of New York, to raise or lower rates. But how does that infernal machine work? Who follows the blueprint, manipulates the levers, and chants the rites to implement an interest-rate change? Let’s peek into the basement of the bank and see what goes on there.

I do not have Superman’s X-ray vision, but I am certain beyond any doubt that neither the Fed Bank of New York nor any other Fed institution has an interest-rate machine. Nevertheless, the popular belief, as emphasized by the newspaper headline “Fed moves to raise interest rates,” must have some foundation in fact. So in what sense did the Fed “raise rates”?

What the Federal Reserve does have is a powerful moneymaking machine that operates through the offices of its New York bank. In activating this machine to raise rates, the Fed’s decision-making board, the Federal Reserve Open-Market Committee (FOMC), issues a directive to the bank’s account manager to sell more or buy fewer government securities in New York’s financial market. This time the directive was to buy fewer. Since the Fed is a major player in the government securities market, when it buys fewer securities it causes the price to fall and their interest rate to increase.

Unlike anyone else who buys something in markets, a Federal Reserve purchase is not made with old money but with brand-new money. The Fed creates the means of payment. If the seller of the securities wants cash, the Fed uses its authority to print new Federal Reserve notes. If the seller wants a check, the Fed account manager has the authority to issue one that becomes new bank reserves when deposited. Since the Fed creates new currency and bank reserves to purchase government securities, the securities are perforce monetized. They are no longer outstanding debt, but by the alchemy of central banking have been converted into money. Likewise, when the FOMC sells securities or buys fewer than it had been buying, as in this case, the quantity of money in the economy is reduced or its rate of increase is slowed.

The action on July 1 called for the account manager to buy fewer securities until the Fed funds rate rose from 4.75 to 5 percent. “Fed funds” are the loans banks make to each other for a 24-hour period. Some banks need extra reserves, others have excess reserves. The Fed funds market resolves these asymmetries. Since Fed funds are an important segment of the reserves commercial banks need to carry on their lending and investing business, any central bank action that constrains reserves raises that particular interest rate.

Monopoly Power Over Money

The answer to the question posed above, therefore, is: the FOMC can raise this one short-term interest rate—the Fed funds rate—for a few days. Its means for doing so, however, is its monopoly power to increase or decrease the economy’s stock of money, not any device that directly alters market interest rates.

Let’s see what happened to other interest rates.

The Federal Reserve Bank of St. Louis publishes weekly a newsletter, U.S. Financial Data, which furnishes week-by-week accounts of the U.S. economy’s monetary and financial data over the most recent 15 months. According to the July 22 issue, the Fed funds rate duly recorded an uptick on July 1 following the FOMC’s action. Most other rates, however, did not follow suit. Corporate AAA bond rates hit a low point in January 1999, rose 100 basis points (1 percent) to June 25, and fell 20 basis points in the weeks after the Fed “raised rates.” Tax-free municipal bonds, which show little interest-rate movement, had risen slightly since October 1998. After the July rate “hike,” their rates too showed a slight decline. Rates for 30-day commercial paper, loans made by nonfinancial companies, were flat for the first six months of this year, rose slightly in June until the rate “hike,” then showed a downtick. Thirty-year Treasury rates hit a low spot in October 1998 and rose constantly (about 100 basis points) until the rate “hike.” After that, they too declined.

The AP report included charts of interest rates on mortgages and Treasury bonds that showed significant increases in rates since the autumn of 1998. So how could the AP claim that the “Fed raised interest rates” on July 1, when most rates had been rising since the previous October and several rates fell after the rate “hike”? Their report was not an example of valid news but of “economically correct” journalism.

Traditional economics properly teaches that many complex market forces—countless investment and savings decisions not dependent on monetary factors—are essential in determining interest rates. The Fed funds rate that Fed policy can influence through its monopoly over the quantity of money is inconsequential in shaping most short-term and long-term rates in capital markets, unless that moneymaking power subsequently promotes a pervasive price inflation.

Federal Reserve policy is responsible for the quantity of money—cash and bank deposits—that all households and business firms have in their possession at any moment. Furthermore, all severe price inflations and contractions (such as the one from 1929 to 1933) result from excesses or deficiencies of central bank money. All of which means that the Fed’s current role in “fighting inflation” amounts to nothing more than undoing things it should not have done in the first place.

By controlling the basic stock of money in the U.S. economy, Fed policy determines the general level of prices. And for a fleeting moment through its control over the money stock, the Fed may influence a few short-term interest rates. But the media claim that the “Fed moves to raise [or lower] interest rates”?

It just ain’t so.

—Richard H. Timberlake
Contributing Editor

ASSOCIATED ISSUE

December 1999

comments powered by Disqus

EMAIL UPDATES

* indicates required

CURRENT ISSUE

October 2014

Heavily-armed police and their supporters will tell you they need all those armored trucks and heavy guns. It's a dangerous job, not least because Americans have so many guns. But the numbers just don't support these claims: Policing is safer than ever--and it's safer than a lot of common jobs by comparison. Daniel Bier has the analysis. Plus, Iain Murray and Wendy McElroy look at how the Feds are recruiting more and more Americans to do their policework for them.
Download Free PDF

PAST ISSUES

SUBSCRIBE

RENEW YOUR SUBSCRIPTION