Federal Reserve watchers are in a tizzy over the central bank’s proposed tightening.
Following the recent Federal Open Market Committee meeting, Federal Reserve officials confirmed they’re planning to hit the brakes. The balance sheet could even shrink in the summer. We might just return to normal monetary policy, something not discussed since COVID-19 nor seen since the 2008 crisis.
Unfortunately, the transition to regular order comes with some baggage. There’s one fallacy that financial and economic commentators seem determined to bring along: the idea that the Federal Reserve "sets" interest rates. We can’t escape money mischief until we put this wrongheaded view behind us. Interest rates can be useful as a barometer for monetary policy. They give policymakers clues about liquidity conditions. But don’t confuse the barometer for the weather.
The Federal Reserve targets a range for the federal funds rate — what banks charge each other for overnight loans. Like most interest rates, this price of rented capital is determined in a market. The Federal Reserve is a big player in this market but does not control it. Yes, the Federal Reserve can influence the federal funds rate by changing the supply of bank reserves. But monetary policymakers can’t make this rate whatever they want. Long periods of low rates, as we currently have, are more due to market forces than the will of central bankers.
If we don’t understand how monetary policy works, we’re likely to err when deciding whether money is loose, tight, or just right. The difficulty stems from the many effects changes in the money supply have on interest rates. Liquidity injections can lower interest rates in the short run by increasing the supply of loanable funds. But longer-run effects work the other way: Increased output and inflation push interest rates upwards. High rates could imply loose money, and low rates tight money. This turns the conventional wisdom on its head.
Excessive focus on interest rates is dangerous. Instead, we should pay attention to what really matters for monetary policy: money itself. It all comes down to supply and demand. Money is loose if its supply exceeds the demand to hold it; money is tight if its supply falls short of the demand to hold it. The price of money, its purchasing power, adjusts to bring supply and demand into balance. This is the old-school monetarist paradigm. Although it’s been updated and extended since the days of Milton Friedman, the basic insight remains sound. The corollary is that interest rates are besides the point. Creating and circulating money is what matters.
This is no ivory-tower quibble. Monetary history is replete with policy failures, many of which stem from a faulty understanding of interest rates. In the 1930s, the Federal Reserve turned a significant, but not fatal, market correction into the Great Depression by failing to counteract a plunging money supply. Why? Because interest rates were low, so policymakers mistakenly thought money was already loose. The contemporary version of this error is the "liquidity trap," the belief that the Federal Reserve is out of ammo when interest rates run up against the "zero lower bound." Nonsense. As long as there are assets to purchase, the Federal Reserve is never powerless.
As the Federal Reserve unwinds its emergency policies, we should watch out for the opposite mistake. Growing output and inflation will eventually cause interest rates to rise. This is a sign of a surging economy, not a sagging one. Rate target hikes by the Federal Reserve should be understood as following broader market conditions instead of determining them.
It’s been a tumultuous decade for monetary policy. With the fallout from the 2008 and 2020 emergencies behind us, we’re ready to return central banking to the realm of the ordinary. Our hardships won’t be for nothing so long as we remember this crucial lesson: Economic stability depends on money supply and demand, not interest rates.
Alexander William Salter is an associate professor of economics in the Rawls College of Business at Texas Tech University, a research fellow at TTU’s Free Market Institute, and a senior fellow with AIER’s Sound Money Project.