Does the Fed Control Interest Rates?

Many economists will tell you that the most important variable to watch to assess the looseness or tightness of monetary policy is the interest rate and, in particular, the federal funds target rate. But while that rate matters and I would certainly want to pay attention to it, neither the federal funds rate nor the Fed’s target for that rate is a good way to assess monetary policy.

To see why, it’s important to understand what the federal funds rate is. The federal funds rate is the interest rate that banks charge each other on overnight loans. Why bother borrowing overnight? Because banks must meet daily the reserve requirement that the Fed has set for them. If a bank’s management sees that it will be, say, $30 million short on a given day, it will go into the federal funds market and borrow that money from other banks that have excess reserves. So notice something interesting: even though the Fed sets a target range for the federal funds rate—the target range is currently zero percent to 0.25 percent—it does not participate in the federal funds market.

Moreover, because capital markets are global, the Fed, though one of the biggest players in capital markets, is not a large player as a percent of the market. Its sales or purchases of bonds are a small percent of worldwide financial assets. The answer to the subtitle above, therefore, is no.

This is an excerpt from David R. Henderson, “Inflation: What Next?” Defining Ideas, December 16, 2021.

Another excerpt, estimating my predictive ability:

I still think, as I said in May, that there’s less than a 20 percent probability that there will be a twelve-month period between May 2021 and December 2022 over which inflation will be as high as 10 percent. Also in May, I gave an 80 percent probability that there will be a time period between May 2021 and December 2022 over which inflation, measured by the CPI, will be 5 percent or more. That prediction, unfortunately, is looking good. Between May 2021 and November 2021, the CPI rose by 3.85 percent. So if in the next six months the CPI rises by just over 1 percent, my prediction will come true.

One of the costs of inflation:

Consider the US federal tax system for individual income before 1985. Back then, even if inflation caused your wages or salary to increase at the same rate as overall prices, inflation put many people in a higher tax bracket. And even those who were not put in a higher tax bracket found that a higher percentage of their income was in their top tax bracket. When that happened, even those whose incomes kept pace with inflation found that their after-tax real income was lower than before the inflation. Fortunately, this ended at the federal level in 1985 when inflation-indexing of tax brackets, which was part of the tax act that President Ronald Reagan signed in 1981, began. Interestingly, former Fed vice-chairman and current Princeton University professor Alan Blinder admitted this point in his 1987 book, Hard Heads, Soft Hearts. But shockingly, he said that unless you’re an economist or an accountant, that cost of inflation “will leave you yawning.” Here’s what I wrote in my November 1987 review of his book in Fortune:

Where was Blinder during the late 1970s? I knew people with only a high school education who noticed instantly that an 8% increase in their hourly rate translated into only a 6% or so increase in their take-home pay, not enough to stay abreast of inflation. They didn’t yawn when that happened—they got mad, which is one reason taxes ended up being indexed.

When I wrote that, I had in mind my secretary, Chrissy Morganello, who completely understood how inflation combined with the unindexed federal income tax to make her worse off.

But the federal tax system is not fully indexed. Inflation creates apparent capital gains that are not gains at all. If you buy stock whose value in dollars rises, and then you sell, you will pay tax on the whole gain, which includes the part that simply compensates you for inflation. I call this a “phantom gain.” Also, the income thresholds beyond which you pay taxes on your Social Security income have not been inflation-adjusted in three decades. Finally, many state governments still have not indexed their state income tax brackets for inflation.

Read the whole thing.