Enough About Interest Rates!

Monetary policy isn’t about interest rates. It’s about money. Specifically, it’s about the supply of money relative to the demand to hold it. But you wouldn’t know that from financial journalists’ constant focus on interest rates. Sentences like “The Federal Reserve lowered interest rates today,” or “Yesterday, the Fed debated whether to start raising interest rates” are all too common. They are also highly misleading.

Financial journalists usually focus on the federal (fed) funds rate. This is the rate banks charge each other for overnight loans. The Fed has a target for the fed funds rate as part of its monetary policy strategy. But the fed funds rate is not an instrument. That is, it’s not something the Fed directly controls. Rather, the Fed sets its federal funds rate target and then uses its instruments to push the federal funds rate toward its target. The federal funds rate might be thought of as a barometer for monetary policy. But it is not the substance of monetary policy. 

What about the so-called administered rates, which the Fed does control? These include the discount rate, which the Fed charges for loans, and the interest rate on excess reserves, which the Fed pays to banks that keep funds in their accounts at the Fed. The discount rate usually doesn’t matter much, because banks try not to borrow from the Fed directly, given the stigma associated with discount window lending. Interest on excess reserves is another story. Especially in a floor system, which the Fed has embraced since 2008, interest on excess reserves matters. But even here the Fed does not have complete freedom. Set the interest on excess reserves too low, and banks won’t keep their funds with the Fed. Set it too high and you choke off economic activity, because banks let capital sit idle rather than investing it in productive projects. The feasible range for interest on excess reserves is determined by factors largely outside the Fed’s control.

It’s very important to separate monetary policy from interest rates. Yes, monetary policy affects interest rates, because changing the money supply by buying or selling assets affects yields. But, ideally, monetary policy keeps these effects to a minimum. Good monetary policy is about allocatively neutral demand stabilization, giving markets the liquidity they need to operate at full employment. If monetary policy were “about” changing interest rates, it would become something entirely different. Interest rates are prices and some of the most important ones in the economy: the prices of various capital instruments, and hence of time and risk. 

If monetary policy purposefully changed interest rates, it would by definition alter relative prices. In market economies, relative prices guide resource allocation. If you believe monetary policy is about interest rates, you must also believe the central bank has better knowledge about the opportunity costs of capital than the market. This seems unlikely, to put it mildly. 

It’s not the central bank’s job to pick winners and losers in the markets by altering the terms of exchange (prices). The central bank’s job is to create a stable foundation for the market process, in the form of monetary equilibrium: not too much money, nor too little, but just the right amount.

We need to change the public conversation surrounding monetary policy. Talking about the Fed’s activities in terms of interest rates is easy, but deeply flawed. It is better to keep an eye on more relevant variables, like the overall size of the balance sheet. Of course, if central bankers start making crazy statements about “yield control,” as they do from time to time, we will have to talk about interest rates. It’s absolutely proper to push back against bureaucrats with minimal skin in the game who try to tinker with the yield curve. But for ordinary Fed policy, strategy, and announcements, keep your eye on money supply and demand. That’s where the action is.