Newspaper headlines across the country on July I
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 I 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, US. Financial Data, which furnishes week-by-week accounts
of the US. 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 I following the FOMCs action. Most other rates,
however, did not follow suit. Corporate AAA bond rates hit a low point
in January 1999, rose 100 basis points (I 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 non-financial companies, were flat for the first six months of this
year, rose slightly in June until the rate "hike," then showed a
down-tick. 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
Reprinted with permission from The
Freeman, a publication of The Foundation for Economic Education, Inc.,
December 1999, Vol. 49, No. 12.
Yourname@libertyhaven.com
