[jmackenzie]

I have a question regarding the Fed’s ability to set (manipulate) interest rates.

1. The Fed prints money with which sends a signal to the market that there is more money available (which should come from savings) which lowers interest rates.

2. They use the printed money to buy Treasuries – how does this keep interest rates down? Are these the same “interest rates” I’m referring to in Point 1 or something different?

3. There is also the federal funds rate.

I don’t understand how these three are related to each other or even if they are. I’m sure I’m missing other ways that they go about their dirty business.

If there is a loss of confidence in Treasuries which causes interest rates to rise would the Fed have to do something with the Federal Funds Rate?

I would really appreciate some help in understanding how this works.

[jmherbener]

The only interest rate the Fed sets as a matter of administrative policy is the discount rate. The discount rate in the interest rate the Fed charges banks for loans they take out from the Fed.

The federal funds rate is the interest rates banks charge to other banks for over-night loans. Banks usually take out such loans to meet their reserve requirements. For this reason, the Fed targets the federal funds rate. If it rises (falls), the Fed takes that to mean that reserves are more (less) scarce.

To manipulate the federal funds rate, the Fed buys Treasuries or other assets from banks and pays for them with cash or checking account balances at the Fed. Either of these counts as reserves for the banks. The larger supply of reserves will reduce the banks’ demand for more reserves through federal funds borrowing and therefore, push the federal funds rate down.

With the greater reserves banks can issue fiduciary media and create credit. The additional supply of credit will push interest rates down in the credit markets the banks lend into, like mortgages or prime loans or AAA bonds.

If there was a loss of confidence in Treasuries, the Fed could just buy more of them to prop up their prices and keep their yields low.

Take a look at Murray Rothbard’s book, The Mystery of Banking:

https://mises.org/Books/mysteryofbanking.pdf

[jmackenzie]

Thank you very much. That helps my understanding.

[j.fournier]

One of my economics professors at University of Virginia espoused the point of view that the Fed was powerless to affect interest rates. My recollection was that the main reason was that he thought their main tool for impacting the Federal Funds rate was through their involvement in the repo market, and that they are only a small fraction of that market. I’ve run into this guy more recently and asked him if he has changed his mind, considering all of the permanent open market operations, and low interest rates post 2008. His response was something like, well take last week for example, they bought a bunch of treasuries and the rates went up. I mentioned the difference between nominal and real interest rates, and he deflected by saying that there was no way that I could prove that the real rate had gone down. This prof is pretty knowledgable about real world stuff (made about $30 million on Wall Street). How could you convince such a person (if you wanted to waste your time) that the Fed is actually able to influence (real?) interest rates?

[jmherbener]

I suppose the first step is to see if he thinks like an economist about markets in general. For example would he agree that if the supply of a good is larger on Friday than Monday, then the price on Friday is lower than it otherwise would have been if the supply had not been larger regardless of whether or not the actual price goes up or down?

If he agrees with this, then the second step is to demonstrate how the Fed’s expansionary monetary policy increases the supply of credit through credit creation by banks.

If he agrees with this, then you can lead him to the conclusion that the monetary inflation and credit expansion generated by the Fed makes interest rates lower than they would be otherwise.

If having accepted this conclusion, he still insists that the Fed is powerless to affect interest rates, he’s probably a hopeless case.

[j.fournier]

Thanks Jeff. I think he may be in the hopeless case category.

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