Has the Fed been Holding Down Interest Rates?

Ben Bernanke, Donald Trump, interest rates, natural rate of interest, Quantitative Easing
Red Light," by Matthias Ripp, CC BY 2.0 https://www.flickr.com/photos/56218409@N03/16273496076

matthias-ripp-imageONCE UPON A TIME, when my twin brother and I were tots, our father convinced us that he could make a traffic light change from red to green whenever he wanted it to. Raising his hand to the light as we sat at an intersection, he would say, “I command you to change to green….now!” cocking his finger at the light for emphasis. Sure enough, the light would change precisely on cue, while two little boys shouted, “Papa, how do you do that!?”

I share this little anecdote because I’m convinced that, if more people had been fooled the way my brother and I were, fewer would be so gullible today as to believe that the Fed has been firmly in control of interest rates these past eight years, and that it is only owing to that control that rates have remained low for so long.

The view that the Fed might have raised interest rates long ago, had it only wanted to, became notorious during the presidential campaign, when Donald Trump publicly accused Janet Yellen’s Fed of keeping rates low for political reasons.  But Trump was merely embroidering a belief common among many (mostly conservative) Fed critics. Writing for Project Syndicate this June, Carmen Reinhart observed that “The US Federal Reserve led the charge among central banks…by relying on a near-zero policy rate … interest rates have been low, and remain low, because policymakers have gone to great lengths to keep them there.” In a March 2015 Wall Street Journal op-ed, David Malpass attacked “The Fed’s belief that near-zero rates lead to growth.” “Private sector dynamism,” he noted, “thrives on market pricing, not artificially low rates.” Similar opinions were expressed by several speakers at the Cato's recent Annual Monetary Conference.

Indeed, the myth that interest rates have been held down by the Fed’s easy monetary policies has been given credence by Fed officials themselves. Their intent, to be sure, hasn't been to fault the Fed. They're merely loath to admit that rates haven't been fully, or almost fully, under its control. Hence Yellen’s bland reply to Trump, that “partisan politics plays no role in our decisions about the appropriate stance of monetary policy.” That, to a Fed bureaucrat, is safer than saying, “Keeping rates low?  Why, we only wish we could raise them!”

Fed Vice-Chair Stanley Fischer displayed unusual candor, on the other hand, in addressing the Economic Club of New York recently. “I am sure,” Fischer said,

that the reaction of many of you may be, “Well, if you and your Fed colleagues dislike low interest rates, why not just go ahead and raise them? You are the Federal Reserve, after all.” One of my goals today is to convince you that it is not that simple, and that changes in factors over which the Federal Reserve has little influence — such as technological innovation and demographics — are important factors contributing to both short- and long-term interest rates being so low at present.

Yet even Fischer, later in that same speech, reverted to the standard suggestion that the Fed was firmly in the saddle. “But, of course,” he said, “Fed interest rates are kept very low at the moment because of the need to maintain aggregate demand at levels that will support the attainment of our dual policy goals of maximum sustainable employment and price stability, defined as the rate of inflation in the price level of personal consumption expenditures (or PCE) being at our target level of 2 percent.”

The unvarnished truth, I hope to persuade you, is that interest rates have been low since the last months of 2008, not because the Fed has deliberately kept them so, but in large part owing to its misguided attempt, back in 2008, to keep them from falling in the first place.

How Rates Got Down

Far from having endeavored, back then, to lower interest rates, Fed officials feared that, as rates approached their “zero lower bound,” monetary policy would cease to be effective.  Although it’s true that during October 2008 the FOMC lowered its federal funds rate target, first from 2 percent (where it had been since the end of April) to 1.5 percent, and finally to 1 percent, it made these changes reluctantly, and did so in each case after the effective funds rate (the median value of actual overnight loan rates) fell well below the targets already in place. Longer-term interest rates likewise fell in advance of the Fed’s target changes, as can be seen from the chart below, which compares the Fed’s funds-rate target to both the effective federal funds rate and the yield on 5-year Treasury Notes. In few words,  by the time the Fed got around to lowering it, the federal funds target had ceased to have any meaning, save as a symbol of Fed officials' vain hopes.


That market rates were in decline before the Fed lowered its policy target is only one of several reasons why it makes little sense to attribute their decline, or their initial decline at least, to “easy” monetary policy. A second is that an easy policy stance ought, ipso facto, to have led to an eventual increase in nominal spending, if not in the rate of inflation. Yet, as everyone knows, neither of those things happened. Instead, as the next chart shows, both headline and core PCE inflation rates fell, and continued to do so for the better part of a year, while the rate of growth of nominal GDP, which had already been declining for some months, fell to below minus 3 percent, and did not begin to recover until July of 2009.


Why Quantitative Easing Didn’t Hold Them There

What about Quantitative Easing? Surely, one might think, the Fed’s large-scale purchases of mortgage-backed and Treasury securities between late November 2008 and October 2014 marked a decisive turn toward easy monetary policy, and hence a source of downward pressure on interest rates. After all, Ben Bernanke himself held that quantitative easing — or what he preferred to refer to as the Fed’s “Large Scale Asset Purchases” — was aimed at lowering long term yields:

Federal Reserve purchases of mortgage-backed securities (MBS), for example, should raise the prices and lower the yields of those securities; moreover, as investors rebalance their portfolios by replacing the MBS sold to the Federal Reserve with other assets, the prices of the assets they buy should rise and their yields decline as well. Declining yields and rising asset prices ease overall financial conditions and stimulate economic activity through channels similar to those for conventional monetary policy.

What’s more, Bernanke claimed that LSAPs had reduced yields in fact:

After nearly four years of experience with large-scale asset purchases, a substantial body of empirical work on their effects has emerged. Generally, this research finds that the Federal Reserve's large-scale purchases have significantly lowered long-term Treasury yields. For example, studies have found that the $1.7 trillion in purchases of Treasury and agency securities under the first LSAP program reduced the yield on 10-year Treasury securities by between 40 and 110 basis points. The $600 billion in Treasury purchases under the second LSAP program has been credited with lowering 10-year yields by an additional 15 to 45 basis points. Three studies considering the cumulative influence of all the Federal Reserve's asset purchases, including those made under the MEP, found total effects between 80 and 120 basis points on the 10-year Treasury yield. These effects are economically meaningful.

If the Fed's critics needed a smoking gun to cinch their case that the Fed deliberately kept rates down, surely this is it!

But once again, things aren't so simple. First of all, the Fed’s purchases represented an obvious easing of monetary policy only in a ceteris paribus sense. Whether massive increases in the nominal quantity of base money amounted to “easy” monetary policy in practice depended on concurrent movements in the real demand for base money. In fact, the demand for base money kept pace with the supply, in part owing to other Fed-orchestrated policy steps. Those steps included the Treasury’s Supplementary Financing Program (SPF), begun in mid-September 2008, and the Fed’s October 8, 2008 decision to begin paying interest on banks’ excess reserves. Their aim was to get banks and the government to park more cash at the Fed, and to thereby assist it in meeting its fed funds target, by preventing the Fed’s asset purchases from contributing to any increase in the supply of overnight funds. At one point, as the next chart shows, the SPF program alone immobilized almost $559 billion in base money, preventing it from serving as a basis for private-sector money creation.


As for interest on reserves, although it failed to establish an above-zero “lower bound” on the effective federal funds rate, as Fed officials originally hoped it would, the policy did succeed, in combination with the ongoing decline in market rates, in getting banks to hoard reserves instead of swapping them for interest-earning assets. The IOER rate has, for most of its existence, exceeded yields on most Treasury securities, allowing foreign banks in particular to profit by arbitraging the difference between the two rates, and making a general preference for reserves over Treasuries as means for meeting new regulatory liquidity needs a no-brainer.

For these and other reasons, the Fed’s unprecedented asset purchases, which might ordinarily have been expected to result in roughly proportional increases in broad money, spending, inflation, and nominal interest rates, affected those variables only modestly, if at all, and did so for the most part by limiting their tendency to decline, rather than by raising them in an absolute sense.

And what about the “significant declines in the yields on both corporate bonds and MBS” Bernanke refers to? Don't they prove that, despite the hoarding of base money, quantitative easing did in fact reduce interest rates, at least on longer-term securities?  Well, yes and no. The empirical evidence to which Bernanke refers is anything but clear-cut. Besides the wide range in the estimates (which some other studies make even wider), the studies suggest that of the several rounds of asset purchases, QE1 alone succeeded in lowering long-run yields generally, and not just on the assets the Fed purchased. More importantly, the estimated reductions were short-run reductions only, with estimated durations of as little as a few months, and no more than a bit over two years. That’s not long enough to account for the fact that rates remain low, despite a recent uptick, to this day.

But don't take my word on that last point. Instead hear our star witness again, on the Fed's long-run influence on rates:

If you asked the person in the street, “Why are interest rates so low?”, he or she would likely answer that the Fed is keeping them low. That’s true only in a very narrow sense. The Fed does, of course, set the benchmark nominal short-term interest rate. The Fed’s policies are also the primary determinant of inflation and inflation expectations over the longer term, and inflation trends affect interest rates, as the figure above shows. But what matters most for the economy is the real, or inflation-adjusted, interest rate…. The Fed’s ability to affect real rates of return, especially longer-term real rates, is transitory and limited. Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth — not by the Fed.

In other words, if QE — sorry, LSAPs — worked as Bernanke (2012) claims, it did so, according to Bernanke (2016), only temporarily. If the purchases appeared to do more than that, it was  because they anticipated rate changes already in the cards, including ones symptomatic of the very same faltering recovery that informed the Fed's decision to engage in large-scale asset purchases in the first place. As Mehmet Pasaogullari puts it (in a paper written for the Cleveland Fed last year), “each round of QE should be viewed as a response to very unfavorable economic conditions at a time when further stimulus to the economy could not be provided by means of the federal funds rate because of the zero lower bound.” LSAPs were, in still other words, the Fed’s way of pointing at sagging interest rates and saying, “I command you to change…now!”

But why trust Bernanke (2016)? We should trust him because both (relatively) tried and true theory (as opposed to the dubious theories that informed Quantitative Easing itself), and the empirical record, agree with him. The tried and true theory is, of course, Knut Wicksell’s. As Larry White observed, in addressing the topic of low interest rates here in July,

In Wicksell’s famous and now-standard analysis, a central bank can drive (or hold) the market rate of interest below the natural rate by injecting money, which shifts the supply of loanable funds curve to the right, increasing the quantity of loanable funds and lowering the interest rate (the “liquidity effect”).  As the new money circulates it drives up prices and nominal incomes, however, which shifts the nominal demand for loanable funds curve to the right, raising the market interest rate (the “nominal income effect”).  If the central bank wants to keep the market rate low in the face of the nominal income effect, it must accelerate the money injection. Short-term real rates have been negative, and nominal rates near zero, for eight years now with little sign of accelerating broad money growth or a rising inflation rate. Thus the Wicksellian cumulative-process scenario does not seem to be a viable candidate for explaining why current rates have remained so low since 2008.

Natural and Fed-Inspired Rate Movements: A False Dichotomy

The alternative explanation — that natural rates have themselves fallen — is supported by a mass of empirical studies, showing that all of the principle determinants of “natural” nominal rates, including expected inflation and total factor productivity, have been trending downward since long before the Fed’s first large-scale asset purchases. Here (once again) is the chart Janet Yellen referred to last December, showing ranges for various natural-rate estimates up to that time:


In attributing low interest rates to low “natural” rates, rather than to the Fed’s large-scale asset purchases, I don’t mean to absolve the Fed of blame for those low rates. On the contrary: I, too, hold the Fed responsible, to a considerable extent, for the fact that rates have been low. I just don't believe that it made them so by pumping too much money into the economy.

As we've seen, rates originally crashed, not because monetary policy was too easy, but because it was too tight. The Fed erred, in other words, not by pushing rates down but by trying to prop them up in the months leading to Lehman’s collapse. Wicksell’s theory is once again relevant. Just as that theory holds that, in order to keep interest rates below their natural levels, a central bank must resort to ever more aggressive monetary expansion, it also implies that a central banks that strives to maintain an excessively high rate target will, by over-tightening, cause spending (or, if you prefer, aggregate demand) to decline. That decline will in turn place downward pressure on market rates, by reducing the nominal demand for funds. The pressure then inspires further tightening, and so on, until the central bank finally relents. The Fed’s efforts to keep rates from approaching the dreaded zero lower bound thus ended up backfiring. Like Oedipus, it appeared fated to achieve the very outcome it desperately wanted to avoid.

All of this still leaves the persistence of low rates unexplained. Wicksell effects can't account for that persistence. Eventually, the realignment of prices, renewed monetary growth, or some combination of the two, ought to have caused rates to recover, ceteris paribus. Instead, it appears that “natural” rates themselves had to have fallen, just as the estimates in Yellen's chart suggest. Can that possibly have been the Fed’s fault?

It certainly could have been, and I believe that it was, at least to some extent. It’s a mistake, first of all, to insist too strongly on a dichotomy of “monetary policy driven” and “natural” interest rate movements, or (what amounts to the same thing) to identify the latter movements with “secular” forces only. Monetary policy can ultimately have a bearing on natural rates themselves; and that, I believe, is what happened in this instance. Although normally rates might only have declined temporarily in response to a collapse in aggregate demand that was itself the result of excessively tight policy, the collapse in this case forced the Fed to abandon its ordinary instruments of monetary control, and to resort to “unconventional” policies instead. The switch to unconventional policies resulted in a substantial increase in uncertainty concerning the future course of interest rates, which served in turn to keep rates low by further dampening an already dampened appetite for investment. Although some of the Fed’s later interventions, and especially its attempts at forward guidance, were aimed at quelling this uncertainty, their success was quite limited.

It’s too early to suppose that the recent upturn in long-run rates — the yield on 10-year Treasuries has risen 50 basis points since Trump’s election, mostly owing to an upward revision in expected inflation — will endure. Still the uptake makes the odds higher than ever that, come mid-December, the Fed will finally increase its own policy rates. If that happens, it will be just another instance of the market dog wagging the FOMC tail.[1] But should you be tempted nonetheless to thank the Fed for finally “raising” rates, I hope you'll be dissuaded by a recollection of my old man, barking commands at a traffic light.


[1] As this post was being prepared for press, Fed Governor Jerome Powell argued, according to CNBC, that the case for a rate hike had strengthened since the Fed’s last meeting. "Incoming data,” he said, “show an economy that is growing at a healthy pace, with solid payroll job gains and inflation gradually moving up to 2 percent." What Mr. Powell neglected to refer to was the “incoming data” concerning interest rates themselves, showing that they were rising whether the Fed wanted them to or not.

  • As always, great insight.

    Hasn't the supply of money, and correspondingly loanable funds, simply outpaced the productive capacity of the economy? With every bout of easy money through lower rates on time and very little risk of loss, have we not, simply pulled forward future demand? Can it be said that easy-money policies are reflexive? That while lower interest rates and explicit and implicit government guarantees are inflationary in the short-run, they are deflationary in the long-run? That lower money rates act as an anchor and push capital out of money and in to financial and investment capital, lowering the natural rate? Hasn't the natural rate on capital, the rate assuming no money, over time, caught down to the anchor, or the money rate?

    Do you believe that Janet Yellen's chart of the natural rate is fundamentally flawed, especially viewing it in hindsight? Wouldn't the natural rate at the end of the dot.com and real estate booms likely be negative, and at the "bottom" positive? If I had capital, was 2007 or 2009 a better time to invest it? Isn't Janet Yellen's chart reflecting a better opportunity in 2007? Does it make sense to say that by the time the Fed (historically) ever gets around to raising the discount rate, the horse is already out of the barn? Making it necessary to lower rates in short order? And, then, they are too slow in raising rates once the economy resets and the natural rate rises?

    I know this is a lot of questions, wondering if I am thinking of this correctly…

    • George Selgin

      "Hasn't the supply of money, and correspondingly loanable funds, simply outpaced the productive capacity of the economy?" No, because were that so we ought to see rising prices, or more robust spending growth, or both.

      I don't see why the natural rate of interest should have been negative after the dot.com boom. Of course the estimates may be wrong; but I knw of none that are clearly better.

      • Spencer Hall

        An excess of savings over investment outlets is deflationary. An excess of money over investment opportunities is inflationary.

    • Milton, we don't have easy money. We have tight money. You can tell because inflation is below target. If money were easy, you'd have NGDP rising at an undesirably high rate, like 1978.

      There is no such thing as pulling forward future demand. If I go on a vacation now, does that mean I won't want to go on a vacation next year? Why not go on both if I can?

      We have had inadequate aggregate demand for eight years now. The Fed has proven that swapping zero-yielding bonds for zero-yielding dollars is not the same thing as easy money: you can wind up with $4T of monetary base sterilized as excess reservers. It's not the size of the monetary base that matters; it's market expectations of future monetary policy that matter. As long as the Fed remains committed to its asymmetric 2% inflation ceiling, money cannot be easy, because everyone knows what the Fed will do if inflation runs a little high (it'll clamp down), but no one can figure out what the Fed will do if inflation continues to run a little low (it does all sorts of random things, from QE to paying IOR to raising IOR higher etc.)

      These problems are all solved by NGDPLT, which is the only monetary policy I know of that deals effectively with inadequate AD at the ZLB.

      • I did not say we had easy money right now. As you suggest, I believe we do have tight money. That is the point I am trying to make. I believe the natural rate is much lower right now than reflected on the chart I referenced and I think it is pretty clear that the natural rate was not 5% at the height of the RE boom in 2006/7, when the Fed used that rate to set their interest rate policy. If it was, the economy would not have collapsed as it did. Ditto going in to 2000 when the Fed was hiking rates then. History is proof that the Fed was too tight then as well. The model, I believe, is completely wrong and has lead to a roller coaster in asset prices and booms and busts in production. Again, we can see with 20/20 hindsight, that their policy has been dead wrong, and it's my suggestion that they re-think their estimates of the natural rate.

        The inflation is showing up in asset prices, not consumer prices. This is not the 1970's and I do not believe we should be comparing now to then.

        There is such a thing as pulling forward demand. Certainly if one has the resources to go on a vacation this year and next, have at it. But, we are talking about credit markets that rely on interest rates and government guarantees and the person on the margin who could not go on vacation, buy a house, car, spend $100,000 on a college degree, etc. this year without low interest rates and government guarantees. This person will not be doing any of these in the future. The demand is pulled forward.

        Low interest rates, declining to zero in real terms over the last 30 years, does not create growth, it creates "secular stagnation". Growth is achieved through savings and ultimately investments in productive capital assets. Higher interest rates encourage savings and ultimately investment. The Fed has had it completely backwards.

        The truth is, it doesn't matter what the Fed does at this point. If they raise rates even modestly the collapse will come sooner than later. If they leave rates where they are, it will take a little longer.

  • Walker Todd

    I commend George as usual for his discussion of the key issues in recent Fed rate-setting exercises here. I am in the camp of those who think the natural rate is or has been lower than the Fed thinks it is. Accordingly, I think the Fed's rate targets have been persistently too high (they were always positive), especially the brief spell, 6 to 9 months or so, in the fall of 2015 and first half of 2016 when the Euro zone and affiliated countries (Switzerland, Denmark, Sweden, et al.) all went resoundingly negative, joined by Japan in the summer of 2016.

    In that kind of world, one has to do a lot of ignoring of the influence of trade on the US economy (not as much as in Europe or Japan but far more than it used to be in the USA) to reason one's way through to full-throated support for further non-market-driven rate increases in the USA. Since the election, roughly, the exchange-traded dollar index reported in Bloomberg (DXY:CUR) has risen from about 95 to over 101. Back in 2000-2002, that index reached 120-122 and was well over 100 for a long time.

    Further interest rate increases will only push the US exchange rate up further. Essentially, raising rates now is like saying, "I can't wait for the next recession; let's bring it on now." We are stuck in that situation until and unless someone big and important (e.g., Japan or Europe) starts growing strongly again and can and does start raising interest rates.

    The deposit rate at the ECB is -40 basis points. The equivalent rate at FRBNY is +50 basis points. An inflow of more capital from Europe to take advantage of the rate differential, especially if it becomes larger due to the Fed raising rates, is just going to make these matters worse. I'll go up when someone else who matters goes up.

    The Fed should simply stop all monetary interventions and let the market set the rates for a good long while. Maybe a generation or so. Maybe forever. — Walker Todd, Chagrin Falls, Ohio, and Visiting Lecturer at Middle Tennessee State University

    • Amen.

    • Walker Todd, I agree with everything up until you said "the Fed should simply stop all monetary interventions". What does this mean? Does it mean telling everyone that the quantity of base money will be fixed forever and the Fed will never again engage in any OMO's? Does it mean abolishing the US dollar, and letting market participants decide what to use as the medium of account?

      • It's an interesting thought experiment to wonder what would happen if the Fed said, "Hey Walker Todd is right!" and credibly proclaimed:

        1. We will never, ever, create or destroy another dollar;
        2. We will never, ever, pay another penny of IOR;
        3. We will never, ever, buy or sell another security (no more OMO's, reverse repos, etc).

        I bet the market would *freak*. The monetary base is 4 or 5 times its normal (pre-2008) size. That implies 400% or so inflation compared with the pre-2008 price level. Whoever's holding the dollars last loses! The dollar would collapse in ForEx. The Dow would go through the roof, bond prices through the floor. I don't know how the Fed could say those things and be credible. But if it succeeded, boy would it be "interesting" … in the Chinese-proverb sense. 🙂

        • George Selgin

          Well, Ken, even I'm not so sure that just getting rid of IOER is enough to give all that hoarded cash wings! But if it were, I would certainly want to amend Walker's list to allow for open-market MBS and Treasury sales sufficient to offset growth in the (dare I use the expression?) base money multiplier.

          I bet, furthermore, that we can get Walker to sign on to this qualifier, since it involves shrinking the Fed!

          • Milton_Hayek

            Agree with all points; further if the monetary base was kept constant after eliminating the 4x increase since 2009, wouldn't that put the US in line for a nice long period of mild deflation and increasing prosperity?

          • Spencer Hall

            "Well, Ken, even I'm not so sure that just getting rid of IOER is enough to give all that hoarded cash wings!"

            Right. The CBs must be driven out of the savings business entirely. Remunerating IBDDs induces non-bank dis-intermediation (i.e., where savings would be exclusively matched with real investment outlets, aka, the Golden Era in U.S. economics).

  • Diego Espinosa

    The piece contains two key statements that bear scrutiny as they are at odds with asset price movements during the period.

    First, a "substantial increase in uncertainty" over future interest rates would show up as a persistent shift higher in expected bond yield volatility. Just the opposite occurred in the post-Crisis period (2010 and later). The CBOE 10yr Tsy Volatility Index fell over the time period. Pre-election, it matched the pre-Crisis (1/1/2007) level. http://www.cboe.com/micro/volatility/tyvix/default.aspx

    Second, you write that there is an "already dampened appetite" for investment. This is at odds with risk asset prices, which improved considerably during the period. That is, if a general sense of pessimism (or uncertainty) over future "aggregate demand' held investment down, then we would see this show up in equity risk premia and bond spreads. While some have made the case that these premia remain (slightly) elevated compared to pre-crisis, it is also clear that the premia consistently fell (i.e. asset prices rose) during the post-crisis period. How can one blame a persistently low natural rate on persistently improving risk appetites?

    • George Selgin

      Perhaps you've misunderstand me, Diego. I do not deny that uncertainty has fallen since 2010; I merely meant to say that the sharp increase in uncertainly way back in 2008 persisted for some time; as you note, there's evidence that uncertainly over the future state of demand still persists. More importantly, I did not claim that increased uncertainty accounts for all of the decline in natural rates since the crisis. I merely claimed that it was responsible "at least to some extent" for that decline. Other factors have clearly also been at play.

    • George Selgin

      FYI, I've added a link in the troublesome paragraph to another paper (Bretscher, Schmidt, Vedolin 2016) I drew on in forming my conclusions. The first figure near the end of the paper is especially helpful. It shows the persistently high rate of interest rate volatility following the crisis, and also its eventual decline, mostly during 2013, toward pre-crisis levels; it also shows that a measure of more general "economic policy" uncertainty remained high and even increased. The last was undoubtedly one of the "other" factors contributing to the continued persistence of low rates.

      • Diego Espinosa

        Granted, George, and I appreciate your reply. However, I do feel the consensus in macro tends to gravitate towards a perceived persistence in pessimism as a key driver of low natural rates. This is highly problematic for a simple reason: as pessimism clearly dissipated (stock and high yield premia plunged; expected vol also fell), the natural rate didn't budge much. This would imply that some other factor kicked in to keep the natural rate low. Policy uncertainty cannot be that factor, as it would also show up in asset prices. It seems we have to find a factor that 1) depresses the natural rate; 2) does not influence asset prices; and 3) increased in intensity over the time period to offset falling risk premia. Note that tight monetary policy and a resulting fall in AD expectations does not fulfill the criteria, as it would also tend to show up in lower asset prices.

        • George Selgin

          These are valid observations. I agree that neither tight nor loose money can account for the persistent fall in interest rates; and I agree that there is much about their decline that continues to mystify me. Whatever the answer is, I hope that the recent upward movement in rates will ultimately shed some light on it!

          • Spencer Hall

            "continues to mystify me"

            It's axiomatic. Never are the CBs intermediaries (conduits between savers and borrowers) in the savings-investment process. The CBs always create new money when they lend/invest. All bank-held savings are lost to investment.

  • George, I love this article, and your "make the light turn green" analogy. There are lots of reasons to be critical of the Fed, but failing to raise the Fed Funds target fast enough is not one of them.


  • Ray Lopez

    Another brilliant post by George! Indeed, from this post you could make the case for falling prices! 😉 more information that the Fed is the ant on a river log that thinks it is steering the log: (Arnold Kling 'Memoirs' book) The sheer size of credit markets is daunting. Deirdre McCloskey pointed out that in 1999, the U.S. monetary base rose by $40 billion, while she estimated the total volume of world assets (real and financial) at $280 trillion. She argues that this made unlikely that the Fed could affect interest rates.[67] [67] McCloskey, Deirdre (2000), “Other Things Equal: Alan Greenspan Doesn't Influence Interest Rates,” Eastern Economic Journal 26:1, p. 99-101. Cited in Jeffrey Rogers Hummel (2013), “The Myth of Federal Reserve Control Over Interest Rates,” Library of Economics and Liberty, http://www.econlib.org/library/Columns/y2013/Hummelinterestrates.html . Note, however, that Hummel takes it as given that the price level is determined by the money supply.

    • George Selgin

      Thanks, Ray. But I hope I won't be understood as claiming that the Fed doesn't influence" rates at all. It can and does influence them, sometimes importantly (and I don't just mean nominal rates); and that influence doesn't necessarily map easily to the size of the monetary base, or any other simple monetary measure. On the other hand, some exaggerate the influence, ignoring other determinants.

      • Ray Lopez

        Yes of course George. I read your paper "The Case for Falling Prices". Even I, a Fisher Black devotee, believes though money is largely short term neutral, there must be some effect on real variables even short term, and of course 'all bets are off' about money neutrality during hyperinflation.

        • Spencer Hall

          "money is largely short term neutral"

          Anyone that actually trades T-bond futures knows that's not true. I predicted AAA bond yields in 1981 and was only off by 1 basis point. Nobody but me can do that.

        • Spencer Hall

          Maybe you should ask yourself how fast does "money" turn over? And that cannot be answered using income velocity.

  • daubigny

    I command that all past, present, and future Chairs of the Board of Governors of the Federal Reserve System read this charmingly informative essay … now!

  • w nieder

    To anyone, if the FRB can not control interest rates
    then why do they bother to raise and lower rates??

    Why are virtually all form of interest at historical low

    Why do we even need the FRS, other than liquidity ??

    • Spencer Hall

      "then why do they bother to raise and lower rates??"

      Because the 300 Ph.Ds. on the Fed's technical / research staff don't know the differences between money and liquid assets. Interest rates are the price of loan-funds, not the price of money. The price of money is the reciprocal of the price level.

      There is no such phenomenon as a liquidity trap.

      • w nieder

        Interesting comments, Mr Hall! I share some of
        your views.

        The only liquidity trap is the one in Krugman's
        bath tub.

        • Spencer Hall

          Krugman is an asshole (and he called me a name first on Zerohedge). Increasing the fiscal deficit is no remedy.
          I sent Yellen's staff my #s today. If they understand them they won't raise rates.

          • w nieder

            Mr Hall, no reason to fall into the progressive gutter.

            I do give, Mr Krugman, credit for one thing – he is
            a cat lover!

            BTW, the FRB, FRS and or the Federal Reserve, is
            a lost cause, just as are most federal departments,
            their payroll staff and policies.

            In 1912, all forty-six Demco senators voted for the

          • Spencer Hall

            I shoot all cats I find in the hedge rows. They kill the game birds. But I feed steak to my dog.

    • Volcker controlled rates and the bond market. Come on guys! But, I think rates are low due to massive demand for bonds. If the Fed senses any decline in those bonds it will attempt to raise rates. If these bonds go bad, as collateral in derivatives trades that would be massively deflationary, right?

  • Benjamin Cole

    Very interesting post.

    I will read it again a few times.

    But for the present, there may be a case the Fed is attempting to hold interest rates "artificially high" through its mysterious reverse repo program.

    Moreover, if you look at interest rates going back to the early 1980s, you see a secular trend: lower and lower.

    How can the Fed (and other major central banks) make rates go lower and lower? Chronically tight money. So I think central banks can, broad brush strokes, control inflation and thus interest rates.

    The problem is, central banks are not statist inflationist organizations, they have morphed into independent, deflationist organizations—in a world in which 80% of bank loans are made on property.


    • George Selgin

      "How can the Fed (and other major central banks) make rates go lower and lower? Chronically tight money." Tight money might of course account for low nominal rates. But it alone can't, so far as I'm able to figure, account for the persistent decline in real rates–not in any direct fashion at least.

      I think economists will be puzzling this one out for some time!

      • w nieder

        Mr Selgin, is not "tight" money followed by
        increasing interest rates?

        Is not "loose" money followed by declining

        Or is economic parlance different from plain sense
        used by public discourse (nominal talk).

        • George Selgin

          Tight money raises interest rates in the short run, but lowers prices in the long run, other things equal. The former effect lasts only until the latter one is complete. Vice-versa for easy money.

          • Spencer Hall

            You don't understand money and central banking Selgin. A "tight money" policy is one where the roc in M*Vt is no greater than 2-3 percent above the roc in R-gDp. But, as in the 1st qtr. of 1981, when money flows were initially tightened, rates fell. Long-term rates revolve around the inflation fulcrum.

          • George Selgin

            I prefer my non-understanding to your understanding.

          • Spencer Hall

            I prefer the truth. I've always made money on every interest rate futures trade. I am the best economic and market timer in history.

          • That is true, but if banks lend more when rates rise, that could result in easy money. Isn't that correct, Mr Selgin?

      • Spencer Hall

        No, this was predicted in the late 1950's. And secular strangulation will accelerate as more and more financing is accomplished by the creation of new money.

    • Spencer Hall

      "How can the Fed (and other major central banks) make rates go lower and lower?"

      As DD Vt decelerated, i.e., money velocity, AD falls. AD = M*Vt. As DD Vt plateaued, monetary savings, funds held beyond the income period in which received, began to exert a dampening economic impact (as predicted in the late 1950s by Dr. Leland James Pritchard). I.e., stagflation was predicted in the late 1950s before the word was coined in 1965.

      Remunerating IBDDs exacerbated this trend. The more money that was bottled up, via a world-wide flight to safety and to safe assets, and the FDIC's unlimited transaction deposit coverage, the more money velocity fell. The expiration of this coverage in 2012 propelled the economy higher in the 1st part of 2013 (hence my call for a "market zinger").

      The fact is that from the standpoint of the economy and the commercial banking system, CBs do not loan out existing deposits, saved or otherwise. CB held savings are lost to both consumption and investment (as anyone who has applied double-entry bookkeeping on a national scale should already know). The source of TDs is DDs, directly or indirectly via the currency route, or thru the CB's undivided profits accounts.

      All savings originate within the CB system, unless currency is withdrawn. And unless savings are expeditiously put back to work, then the economy is dealt a blow. And the only way savings are activated and put to work is if their owners invest them directly or indirectly via non-bank conduits. Money flowing through the NBs never leaves the CB system. The NBs are the CB's customers.

  • w nieder

    Gee, what happen to interest rates when
    Volcker increased federal fund rates to 20% ??

    Of course the Central Bank has absolutely no
    influence over interest.

    • George Selgin

      I never claimed (as anyone who reads my post with any care might ascertain) that the Fed has no influence at all on interest rates! Of course it influences nominal rates through it's influence upon both actual and expected inflation. It also influences real rates through tightening and loosening (the Wicksell or "liquidity" effect), but this last effect is never permanent. Real rates also have non-monetary determinants, and these are largely beyond any central bank's control. The question my post addresses is whether these other factors, or Fed actions, were behind the persistently low rates since 2008.

      Here is a good rule for engaging in discussion and debate: do not start out by assuming that the person you are inclined to disagree with is a fool: it is OK to come 'round to that conclusion, but not to start there unless you have some independent reason for assuming that you are dealing with a nincompoop!

      • w nieder

        My dear Professor: Thank so kindly for your reply.

        It is I whom is a fool and nincompoop (love that word) and
        hardly the author of this thread.

        I read your prose until the first chart. Yes, indeed, market
        forces play an additional role in determining interest rates,
        however, the principal actor is the one and only FRB.

        " The question my post addresses is whether these other factors, or Fed actions, were behind the persistently low rates since 2008."

        It should be noted that in the early 2000's, A, Greenspan had
        already commenced to what I call FedZero; to drive economic
        growth through the use of FRB's policy (central planning). This
        was conclude by "Chairman" Bernanke. Just as the BOE has
        uttered on it's website, Bernanke stated that the purpose of
        QE was to generate more bank loans and thus stimulate
        economic activity.

        I dare say to all, that the FRB had absolutely no idea what the
        results of QE would be. In fact, other have suggested that QEs
        was really designed to repair the badly destroyed balance
        sheets of all too many businesses. It was a bailout of historical
        magnitude and it is what the Beltway does best, address all problems with additional taxpayer funding.

        Since the existence of the FRB (1913), the answer has always
        been the classic lowering of Federal Fund Rates. Now, however,
        a second approach was required to rescue the failing machinery of the FRS?

        In all too many ways, economics is so complex, that it is beyond
        the fragile human mind and those with the least of expertise
        and solutions are the owners and operators of the FRB.

        I will finish the read of you piece, Professor Seigin.

        Your humble student.

    • Spencer Hall

      That's a myth. Volcker never tightened monetary policy except for the 3 months in early 1980.

  • Spencer Hall

    "All of this still leaves the persistence of low rates unexplained"

    Wrong. Secular stagnation was predicted in the late 1950's. It was activated, as predicted in May 1981, due to the saturation in commercial bank financial innovation (the demand deposit turnover apex).

    AD = M*Vt, and not N-gDp – as Keynesian economists define it. Vt collapsed because IBDDs were remunerated. N-gDp has persistently decelerated as more and more savings are bottled up. Remuneration of IBDDs exacerbated this deceleration in Vt. The 1966 S&L credit crunch is the economic paradigm. If an economists can't explain 1966, then they should get a new job.

    • George Selgin

      Well, I can predict anything so long as if I get to keep the "activation" date to myself!

      Seriously, if you read the secular stagnationists of the 50s (e.g., Alvin Hansen), you t will find that their hypotheses positively rule out the possibility of a decades-long "delay," much of which involved robust productivity growth! In his book, _The Bogey of Economic Maturity_, George Terbough blew their fallacies to pieces.

      In that same book Terbough reminds us of a prior generation of stagnationists, ca. 1890 or so, who believed that the "closing of the frontier" (that is, the settlement of the western lands) who bring an end to growth. By your logic, they too were right all along, allowing for a 110-year "activation lag."

      • Spencer Hall

        ? You have learned your catechisms. And you quote the man who wrote
        the Fed's "Bible", who has never been right about almost everything, esp. the DIDMCA (correspondence 8/25/80).

        You should try to learn by asking questions, instead of making fun. Gilbert is blinded by the same dogma you are. The NBs are not in competition with the CBs. The NBs are the CB's customers. Money (savings) flowing thru the NBs never leaves the CB system as anyone who has applied double-entry bookkeeping on a national scale should already know (correspondence to Gilbert Sept. 30, 1979).

        I cracked the economic code in July 1979 (on the back of my mentor Dr. Leland Pritchard, Ph.D., Chicago, 1933). Economic prognostications within 1 year are infallible. 4th. qtr. R-gDp will be lower than 3rd qtr. 1st qtr. 2017 will be lower than 4th qtr. 2016.

        – Michel de Nostredame

        • Spencer Hall

          "Well, I can predict anything so long as I get to keep the "activation" date to myself!"

          That "date" was already baked in the theory. See:
          Lester V. Chandler theorized at the 1961 Conference on Savings and Residential
          Financing in Chicago, Illinois

          • Spencer Hall

            And there is no: "decades-long "delay," N-gDp and R-gDp have been decelerating since 1981 (the apex in DD Vt) along with long-term interest rates. There is a decades long "decay".

          • w nieder

            Mr Hall, not so according to the FRB's history department.

            "Throughout the late summer and early fall of 1979, the Federal Reserve under Volcker had begun pushing the federal funds rate slightly higher."

            "As a result of the new focus and the restrictive targets set for the money supply, the federal funds rate reached a record high of 20 percent in late 1980."

            As you can see, it was close to 1 & 1/2 years of rate
            increase. I remember that event rather clearly, at
            an age of 31.

          • Spencer Hall

            w nieder:

            You have no idea what you're saying. And the Fed has no idea what they're doing. I was trading futures then for my own account and as a commodity broker for others.

            Volcker simply let the economy burn itself out.

            On October 6, 1979 Paul Volcker, Chairman, Board of Governors of the Federal Reserve e System promised that the Fed was going to mend its ways. Hereafter the Fed would deemphasize the control of the federal funds rate and concentrate on holding the monetary aggregates in check. We were advised to “watch the money supply”.

            For approximately the first four months following this pronouncement the money supply increased at an annualized rate of 20 percent… Up from the 8 percent increase in the prior five months… Obviously there had been no significant change in monetary policy. Why? Apparently the Manager of the Open Market Account who operated from an office in the Federal Reserve Bank of New York and who is in charge of all open market purchases and sales for all 12 Federal Reserve banks decided there should be no change in monetary policy.

            Note: the actual monetary policy of the Fed during the 1980 was only nebulously related to the official policies of the Federal Open market committee (FOMC) as published in the Federal Reserve Bulletin. Open market purchases were of such a magnitude in this period member bank legal reserves expanded at an annualized rate of 20 percent. The excessive increase in the money supply made possible by this growth in reserves was accompanied by a continuing rise in the transactions velocity (rate of turnover) of money at an annualized rate of 24.9 percent. Consequently monetary flows (aggregate monetary purchasing power) shot up to annual rate of 33.3 percent –an excessively easy money policy in view of the virtual stagnation of real GDP growth during this period.

            Paul Volcker’s version of monetarism (along with credit controls: the Emergency Credit Controls program of March 14, 1980), was limited to Feb, Mar, & Apr of 1980. Even with the intro of the DIDMCA, total legal reserves increased at a17% annual rate of change, & M1 exploded at a 20% annual rate (until 1980 years’-end).

            Why did Volcker fail? This was due to Volcker's operating procedure. Volcker targeted non-borrowed reserves when at times 10 percent of all reserves were borrowed. One dollar of borrowed reserves provides the same legal-economic base for the expansion of money as one dollar of non-borrowed reserves. The fact that advances had to be repaid in 15 days was immaterial. A new advance could be obtained, or the borrowing bank replaced by other borrowing banks.

            It was before the discount rate was made a penalty rate in Jan 2003. And the fed funds "bracket racket" was simply widened, not eliminated.
            Monetarism actually has never been tried.

            Then came the "time bomb", the widespread introduction of ATS, NOW, & MMMF accounts at 1980 year end — which vastly accelerated the transactions velocity of money (all the demand drafts drawn on these accounts cleared thru demand deposits (DDs) – except those drawn on Mutual Savings Banks (MSBs), interbank, & the U.S. government).
            This propelled nominal gNp to 19.2% in the 1st qtr 1981, the FFR to 22%, & AAA Corporates to 15.49%. My prediction for AAA corporate yields for 1981 was 15.48% & that bonds would bottom in Oct.

            By the first qtr. of 1981, the damage had already been done. But Volcker errored again (supplied an excessive volume of legal reserves to the banking system), in late 1982-83.

          • George Selgin

            This account doesn't square with the official money growth figures, at least not for M2, which show annual growth rates of 7-10% during 1979-82 inclusive.

          • Spencer Hall

            M2 is not a valid money metric. 95 percent of all demand drafts clear thru DDs.
            And the money #s are increasingly overstated. The Fed never revised their definitions after the DIDMCA.
            And Dr. Richard Anderson's reconstructed reserves are specious.

          • Spencer Hall
          • w nieder

            Mr Hall said "You have no idea what you're saying. And the Fed has no idea what they're doing."

            You are right about one. The FRB had no idea what
            the end result of QE would be – they were GUESSING
            at best. The word guess is not part of an economist's
            lexicon, verbiage or diction.

            What Volcker did, was to drive the golden spike
            into inflation – killing it.

            Author Burns, failed miserably to control inflation.

          • Spencer Hall

            No, Volcker let the economy burn itself out. He sat back and smoked cigars. The CEO of Sprint flew Dr. Leland Pritchard on the corporate jet to DC in a forced meeting with Volcker in early 80. Volcker is deaf dumb and blind. Arrogant and ignorant.

  • Andrew_FL

    This is an extremely crude overlay but it's the best I could do on short notice without the data from Yellen's chart:

    These "natural rate estimates" strike me as an attempt to fit a model to the behavior of interest rates over a particular period of the data. Not that they do not actually indicate rates were too high during 2008 itself.

    • George Selgin

      Well Andrew, the chart summarizes estimates arrived at using more than one method. But theory suggests in any case that actual rates cannot differ from natural ones for very long, so that the two are bound to be correlated.

    • Spencer Hall

      No such phenomenon as a "natural rate of interest". Interest is the price of loan-funds, not the price of money. The price of money is the reciprocal of the price-level.

      • Andrew_FL

        I'm not sure how that's relevant to literally anything I said but the concept of the natural rate has nothing to do with any misunderstanding of what interest rates are.

  • Benjamin Cole

    review the new Richmond paper on Arthur Burns.

    The rehabilitation of Arthur Burns has begun!

    Seriously, an important paper, especially for what it says about Fed policy for the last 40 years. Very plausible.


  • w nieder

    If one compares a sixty year chart of Federal Fund Rates
    and the Ten Year Treasury, they both virtually track one



    Gee, five year and thirty treasuries also track the FF rates as well.

    Is this relevant or not?

  • w nieder

    Here is Bank Bernank, explanation as to why
    interest rates are so low and likely to stay so.


  • "it made these changes reluctantly, and did so in each case after the effective funds rate (the median value of actual overnight loan rates) fell well below the targets already in place."

    "As we've seen, rates originally crashed, not because monetary policy was too easy, but because it was too tight. The Fed erred, in other words, not by pushing rates down but by trying to prop them up in the months leading to Lehman’s collapse."

    " it also implies that a central banks that strives to maintain an excessively high rate target will, by over-tightening, cause spending (or, if you prefer, aggregate demand) to decline. "

    If the effective rate was already falling, then why did it matter that the Fed kept its rate high? After all, banks could get loans from each other cheaper than from the Fed. I'm not criticizing. I honestly don't understand. It seems that the falling effective rate would have stimulated AD.

    "That market rates were in decline before the Fed lowered its policy target is only one of several reasons why it makes little sense to attribute their decline, or their initial decline at least, to “easy” monetary policy"

    What about expectations? Wouldn't the market rates have fallen in anticipation of what the Fed was about to do?

    "A second is that an easy policy stance ought, ipso facto, to have led to an eventual increase in nominal spending, if not in the rate of inflation."

    Isn't the lag between policy changes and the effect on inflation can be as high as 5 years to max impact.

    "which served in turn to keep rates low by further dampening an already dampened appetite for investment."

    Yes, and the mountains of cash corporations are sitting as well as buying back their own shares show and limited desire to invest.

    " If that happens, it will be just another instance of the market dog wagging the FOMC tail"

    If the Fed merely follows the market, what good is it? When does the Fed lead the market?

    It seems that the old saying that the Fed starts an artificial expansion but the real economy ends it is accurate.

  • w nieder

    Hear is another Professor and a Catoe scholar
    agreeing with Professor Selgin, also a Cato scholar.


    Despite the arguments of both learned men, there is little in ways
    to quantify to what extent either the FRS or the general markets
    control the direction of interest rates other than to suggest both are
    indeed leading factors.

    I am sorry, however, the match is a complete draw. 1/2-1/2

  • w nieder

    This is Uncle Ben's opinion on this topic:

    " The Fed’s ability to affect real rates of return, especially longer-term real rates, is transitory and limited. Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth—not by the Fed."

    If this is indeed true then the FRB is not needed. Long term real rates
    are transitory, then why have 30 year mortgages been at record low
    rates for nearly some eight years?

  • Weierstrass

    Maybe I'm late, but still…
    Regarding the first picture, I made two different versions. In the first one, we can see that monetary-base changes are inversely correlated with the effective federal funds rate (EFFR).
    ( https://uploads.disquscdn.com/images/1eea726b0148ad9775e744e8caf1214ea7f96c4b9caf3777ec48dad24585c0cf.png )
    In the second one, we can see daily data. On september 2008, we can see firstly a drop in the EFFR well below the federal funds target rate (FFTR), and then a rise well above the FFTR. On October 7, FFTR was at 2%, while EFFR was at 2.97%. The day after, FFTR was reduced to 1.5% and EFFR decreased to 2.24%.
    ( https://uploads.disquscdn.com/images/473d7dd4c23358d04466be829e58a4effc7405576b49634d03f59f6802a74899.png )
    For sure, market forces influence interest rates, despite interventions of the Federal Reserve. But, in this particular case, it seems to me that the Federal Reserve was still the "major player". Am I wrong?

    • Weierstrass


    • George Selgin

      If you extend the chart a little further, you'll see clearly that the Fed, after appearing to regain some influence, looses control of the ffr. It's policies have some impact or "announcement" effects; but then the downward drift in the effective rate continues.

    • w nieder

      Strass, three years from now ALL rates
      including the FRB will be higher.

      BTW, could someone please show me when
      the Central Bank's rates were higher than traded
      bonds, notes and mortgages ?

      All I need is a SINGLE example over a two to
      five year period.