By Jeffrey Rogers Hummel
The fixation on interest rates as the central bank's daily operating target emerged—or, more accurately, re-emerged after having been temporarily discredited by monetarism—during the 1980s. Financial deregulation and assorted other factors caused the predictable relationship between the money stock and such variables as the price level to break down in the short run, as money demand (and its reciprocal, velocity) behaved more erratically than in the past. So central bankers threw up their hands, concluded that monetary targeting was unworkable and returned to focusing on interest rates.
There is no denying that central banks have some impact on interest rates, in both the short and the long run. But the complexity of and qualifications to that impact have been swept into a memory hole, submerging a host of additional questions. How strong or weak is the initial effect on interest rates, and can its strength vary over time or with institutional arrangements? How long does the effect operate after a change in the rate of monetary growth? Does any impact on real rates eventually disappear completely, or can a constant rate of monetary growth make it permanent? Exactly what interest rates are initially affected by monetary policy: only short-term rates or rates across a broad spectrum of maturities extending even into real assets? Addressing these questions exposes serious constraints on the magnitude, duration, and predictability of the Fed's actual control over interest rates. The conventional impression of precise central bank management of even short-term rates turns out to be, at best, highly exaggerated.
It is almost an article of faith among economists, politicians, and the public alike that central banks, such as the Federal Reserve (Fed), have total control over some critical interest rates. This faith applies across the political spectrum and, with only a few notable exceptions, across the policy positions that divide academic economists. Yet this near universal belief is inconsistent not only with standard economic theory and received economic history, but also with what is still taught in many mainstream economic texts. As Milton Friedman put it as late as 1998, "After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die."
There is no denying that central banks have some impact on interest rates, in both the short and the long run. But the complexity of and qualifications to that impact have been swept into a memory hole, submerging a host of additional questions. How strong or weak is the initial effect on interest rates, and can its strength vary over time or with institutional arrangements? How long does the effect operate after a change in the rate of monetary growth? Does any impact on real rates eventually disappear completely, or can a constant rate of monetary growth make it permanent? Exactly what interest rates are initially affected by monetary policy: only short-term rates or rates across a broad spectrum of maturities extending even into real assets? Addressing these questions exposes serious constraints on the magnitude, duration, and predictability of the Fed's actual control over interest rates. The conventional impression of precise central bank management of even short-term rates turns out to be, at best, highly exaggerated.
