Recognizing who\what Really Controls Interest Rates

Just in case there was any doubt about what really controls interest rates, the past couple of months should dispel any lingering doubts.  The Federal Reserve(The Fed) is without a doubt in full control of interest rates going up or down.Money Graph

Back in spring, the Fed hinted that it was going to ease up on “Quantitative Easing” or QE3.  Quantitative easing, for those who don’t know, is the Fed trying to flood the market with dollars by buying stocks and bonds(*True Story)  They call it Quantitative Easing to make themselves sound smarter than you(*Not a true story).

So guess what happened?  Interest rates have been steadily rising this summer.  Despite that, many people mistakenly believe that interest rates are determined by a “Free Market” or by “bond vigilantes”.  The only time “the market” really gets involved is when they start trying to guess at what the Fed is going to do.  That was demonstrated last Wednesday.  The Fed said nothing, the market reacted as if that meant interest rates were going to go up.

The policy implications for this are immense.  I won’t get into all of them on this little post.  But let’s just start at the bottom.  The Fed sets interest rates.  That is a fact, once that cannot be denied.  Whether or not that is desirable is a different argument.  But, right now, the only thing standing between a 0% interest rate, or a 40% interest rate is a whole bunch of wealth, well-connected bankers.

No amount of budget deficits or surpluses can change that fact.  Granted, the bankers may make their decisions based on federal budgets or the health of the economy.  But the decision is still in the hands of a small number of people, not “the market”.

All that Bunk About Deficits and Skyrocketing Interest Rates

It is astounding how long experts can keep repeating the conventional wisdom in the face of -what SHOULD be – overwhelming reality.  The way things work today, the Federal Reserve sets the interest rate.  Additionally, inflation is determined primarily by aggregate demand.  We have nearly 5 years of data backing this stuff up.  Yet, the conventional wisdom marches on.

The federal reserve very plainly sets the (short-term) interest rate.  That is what they do.  It’s called an Open Market Operation. When they want interests to go down they buy U.S. bonds.  That puts cash in the system and lowers interest rates.  When the Fed wants interest rates to go up, they sell their stock of U.S. bonds and remove cash from the system.  In this way the federal reserve sets the interest rate on U.S. bonds which then in turn influence other interest rates(like mortgages and car loans).  This isn’t a secret.  They explain it on their website.

Despite this, we have deficit terrorists running around telling us that we need to cut social security and gut medicare right now! This very instant!  Because if we don’t, interest rates will spike.  We’ll have to start paying 150 bazillian% (Note:  not a real number) on the federal debt and our mortgages.  Pete Peterson, the stereotypical deficit terrorist, states the conventional wisdom very plainly.

I see two potential crises in the future: a near-term financial crisis rooted in declining investor confidence that leads to sharp rises in interest rates and forces sudden, draconian changes in the federal budget; and a longer-term economic crisis that would result from diverting more and more of our national resources to servicing debt instead of investing in areas that are essential to long-term growth. These crises are made all the more likely by the fact that growing debts aren’t just an American problem. Projections show that, by 2035, the world’s advanced economies could face debts approaching 200% of their GDP. With countries competing for scarce capital, interest rates are almost sure to rise steeply.

(emphasis added)

We are now on fiscal year 5 of approx trillion-dollar budget deficits.  I’m still waiting on those mythical bond vigilantes to spike our interest rates.

With that in mind, I found two news stories that are oh-so interesting.  The first is that Mortgage rates hit a new record low last week.  So much for worrying about skyrocketing interest rates…  But what about U.S. bonds?   Maybe those are skyrocketing?  They are still insanely low.  On top of that, there was a bond auction this week where, for every 1$ in U.S. treasuries being sold, 3.16$ was bidding to buy them.  That is a record high amount of bids.  So despite low interest rates and high budget deficits, bond holders are not only sticking with U.S. bonds, but are flocking towards them in record numbers.

In both cases, it is because the federal reserve is purposely keeping the interest rates low.  They always keep it low when they want it low and always keep it high when they want it high.  At this point, I expect someone who is well-versed in the conventional wisdom to grab his or her hair and shout, “Fed keeping interest rates low?  zOMG!  Hyperinflation!  Weimer!  Printing Press!”, and then their head explodes(Note:  I cannot be held liable for exploding heads).  All I have to say is that I am still waiting on that hyperinflation.

The small, but growing community of Modern Monetary Theory(MMT) economists can explain this phenomenon better than conventional economists.  They understand how Modern money works.  How Inflation an interest rates are really set.  Unfortunately, the conventional wisdom doesn’t want to hear it.  Instead, we continue to have both presidential nominees talk about budget deficits without anyone asking to explain the supposed problem.

Sen. Sanders showing MMT some love while reforming Fed

Back in October, Senator Bernie Sanders put together a panel of economists and other public policy experts to come up with a plan to “reform” the Federal Reserve structure.  As his news release makes clear, there is a lot of room for improvement.

Sanders announced formation of his expert advisory panel in the wake of a damning report that faulted apparent conflicts of interest by bank-picked board members at the 12 regional Fed banks.

Top executives from Goldman Sachs, J.P. Morgan Chase, General Electric and other firms sat on the boards of regional Federal Reserve banks while their firms benefited from the central bank’s policies during the financial crisis, the Government Accountability Office investigation found. The dual roles created an appearance of a conflict of interest, according to the GAO.

The surprising part was that the panel had a significant number of MMT economists.  People like L. Randall Wray, William Black, James Galbraith, and Stephanie Kelton.  With all that MMT on the council and the strong showing from the UMKC economics department, I’m optimistic about the reforms they’ll come up with.  Wray has been writing about the Fed since being on the panel.  I think it gives a little hint of the kind of things he and other MMT economists are recommending.  Here’s links to his articles:

Time to abolish the Fed?  Maybe Andrew Jackson was Right.

MORE SECRETS OF THE TEMPLE: Time to Demand Transparency and Accountability of Our Public Stewards

BERNANKE’S OBFUSCATION CONTINUES: The Fed’s $29 Trillion Bail-out of Wall Street

BERNANKE’S OBFUSCATION ON THE 29 TRILLION DOLLAR BAILOUT: RESPONSE TO CRITICS

The $29 Trillion Bail-Out: A Resolution and Conclusion

The title’s alone are encouraging and give you an idea of what he’s writing about.  I highly encourage reading all of them.  It (hopefully) is a preview of the final recommendations the panel will deliver to the good Senator.

How We Currently Control Inflation

I laid out all the bad things about inflation and why it should be kept low and steady.  So how does our policy makers currently control inflation?  By trying to wreck the economy.  Long ago, congress entrusted the federal reserve to conduct monetary policy to promote “promote maximum employment, production, and purchasing power“.  The people at the federal reserve have tried many different things to stop inflation and encourage “full employment”.  In the end, the tool they use most often is by setting interest rates.

When unemployment is high, the federal reserve leaders lower interest rates.  This encourages people to borrow money to buy stuff which creates demand.  It also encourages businesses to expand and invest which increases demand and creates jobs.  Unfortunately, all that borrowed money increases the money supply and all that spending and investing can increase demand faster than supply.  All of this combines to cause the inflation rate to rise.  Once that happens, the federal reserve leaders decide to raise interest rates.  This discourages consumer borrowing and business investment.  Those two things cause unemployment to rise.

So, when I say that we control inflation by wrecking the economy.  This is such an accepted and non-controversial idea, that the federal reserve freely admits that they willingly cause unemployment.

Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.

So why do these people constantly vote to wreck our economy, and why does congress let them?  It’s not because their evil.  It’s not even because their stupid.  It’s just that it’s the only way they know how to control inflation and think it’s the best way to control unemployment.  It’s a way of thinking based heavily in the Monetarism school of economics.  It is pretty much the dominant economic theory in congress and government, business, and even the International Monetary Fund.

They believe that both some inflation and some unemployment is a good thing.  The belief is that having a little bit of each will keep both of them low.  It’s a good theory that I think is a correct observation.  My problem is with the solution.  Causing unemployment and all the problems it causes society(poverty, loss of work ethic, disrupted families) is a very high price to pay for price stability.  Unfortunately, it’s the best our mainstream thinking offers.  Given that, I understand why they do it, I just think we should be actively looking for a way to lower inflation without causing massive unemployment.

I bring this up for a reason.  When talking about other possible solutions, I think it’s important to compare those solutions to what we currently do.  Right now our only solution to lowering inflation means that people must be laid off and rendered unemployed.