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Interest Rates as Monetary Policy

January 11, 2013

The Fed doesn’t directly control interest rates. It performs open market operations and announces a target for the federal funds market. But people don’t criticize the Fed based on whether they actually hit their fed funds target; they base their criticism on other economic variables, such as NGDP, unemployment, or inflation. If the fed funds rate were -5%, 17%, or even 50% and unemployment was 5% and inflation was 2%, no one would be up in arms. If the Fed missed hitting their fed funds rate by 5% or more every single day of the year, no one would care one bit so long as inflation and unemployment were at reasonable levels. Not only that, but over the medium run, the relationship between interest rates and monetary policy reverses. More OMOs causes interest rates to dip temporarily, but a sustained policy of more OMOs will cause higher interest rates as banks begin to expect higher inflation and more growth. Some economists have compared interest rate targeting to balancing a pole on your hand. If you want the pole to move one way in the “long run” you need to move your hand the the opposite way in the short run. If a central bank merely describes the short term interest rate goal, that neither pins down a specific inflation target or even gives evidence which way they intend to move long term rates. Interest rates are a poor way to describe policy. I think it is better to define a long term goal that people actually care about and judge policy success on whether it hits that target. Everything other than the central banks’ target is endogenous!

fed funds and ngdp
Note: On August 15, 1971, the U.S. went off the gold standard. Before that date, interest rates were endogenous in order to maintain the price stability of gold.

Further Reading:
Sumner comments on this topic
Mankiw comments on this topic.

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