TO all The FED watchers: Good reading! GH
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March 22, 2001
Commentary
So You Thought the Fed
Set Interest Rates?
By Arthur B. Laffer, chairman of Laffer Associates.
On Tuesday, like Moses of old, Alan Greenspan brought the tablets down from
the mountain to the people. The word engraved in stone was a 50-basis-point
drop in the discount rate. And the earth shuddered and markets faltered.
Some even went so far as to second-guess the great man. But the word is what
the word is. For the time being the decision is final.
Mr. Greenspan, in my opinion, did just what he had to do. What astounds me,
however, is why anyone cares or why anyone was surprised. The Fed is
enormously important for the U.S. and world economies, but not because it
changes the discount rate or the targeted federal funds rate. All this
hoopla over the Fed's rate changes is misplaced.
Totally Irrelevant
First of all, the discount rate borders on being totally irrelevant because
virtually no one borrows from the Fed. The discount rate is literally the
interest rate the Fed charges member banks for borrowing reserves. At
present, member banks have about $34 million (yes, million) borrowed from
the Fed, and that number has stayed below $1 billion for a long, long time.
Total member bank reserves -- which consist of vault cash and deposits at
the Fed -- total $67 billion. Borrowed reserves are less than 1/2 of
1/1000th of this sum.
Second, the discount rate always follows the three-month Treasury bill rate.
The Fed is never proactive when it comes to the discount rate, save for
perhaps the time it takes the Fed to follow the T-bill rate. In January, the
Fed announced a discount-rate cut of 50 basis points four weeks prior to a
scheduled meeting -- only the fourth time since 1994 that the Fed changed
the discount rate between scheduled meetings -- but that change in the
discount rate still followed a greater than 50-basis-point fall in the
T-bill rate. This is about as proactive as the Fed gets.
Between the last 50-basis-point discount-rate cut to 5% on Jan. 31 and
Tuesday's 50-basis-point cut to 4.5%, the three-month T-bill rate fell to
4.38% from 4.86%. The Fed's move was right on schedule. And, although the
Fed has historically exercised some latitude in when and by how much it
follows changes in the three-month T-bill yield, it still always follows
those changes.
There sure as heck is no new information in this widely anticipated Fed
move. So, where's the beef? Judging from the press and the stock market,
you'd think the world was coming to an end.
The reason the Fed follows the three-month T-bill rate is simple: If the two
rates got too far out of line, borrowing would either go to zero or
infinity. That's the nature of incentives. Banks can borrow reserves from
the Fed at the discount rate and lend those funds risklessly at something
akin to the three-month T-bill rate. If the three-month T-bill rate gets
much higher than the discount rate, member banks will borrow all they can
for a guaranteed profit. Just imagine how much you'd borrow from the
government if it would borrow back from you those funds at much higher
rates.
If, on the other hand, the discount rate far exceeds the three-month T-bill
rate, only those banks in desperate straits would ever borrow. The real cost
of borrowing reserves from the Fed is the differential between the discount
rate and the three-month T-bill rate -- not the level of the discount rate.
The Fed has no choice but to move the discount rate in sync with the
three-month T-bill rate.
In addition, the so-called federal-funds target rate set by the Fed couldn't
be more vacuous. Just what does it mean when the Fed says it's going to
target a rate that is determined in a market -- interbank loans -- in which
the Fed is not a participant? If that isn't jawboning, I don't know what is.
And a jawbone without teeth isn't much of a threat.
All of the interest rate hoopla surrounding the Fed's Open Market Committee
meetings is nothing but a sideshow. I too wish the Fed could just wave a
wand and change interest rates, but it can't. In the near term, the Fed has
very little power to do much of anything. In the long run, however, the Fed
is the single most powerful force in our economic universe. It can and does
move planets and change the world. But it doesn't change the world by
directly changing interest rates. The key to the Fed's power is its total
control over the monetary base -- the sum of currency in circulation, vault
cash and member-bank deposits at the Fed.
Conceptually, there are three stages of monetary policy linking Fed actions
on the monetary base to the overall economy. First, the Fed controls the
monetary base. It increases or decreases the monetary base by buying or
selling bonds in the open market. Second, the monetary base, in conjunction
with reserve requirements, determines bank liabilities. And finally, bank
liabilities along with real output give us the overall price level. In
dynamic terms, the rate of growth of the monetary base ultimately determines
inflation, interest rates, the price of gold, exchange rates, etc. By
controlling the monetary base, the Fed really does control our nation's
destiny and probably the economic well-being of the world.
Back in 1999, the Fed made an understandable error, but an error
nonetheless, by expanding the monetary base far too rapidly. It feared a Y2K
run on the banks. To doomsayers' chagrin, the run on the banks never
materialized, but the excessive growth of the monetary base did push
interest rates, the Nasdaq, and real economic growth way too high. Fed
policies have consequences.
Early last year, the Fed realized its error and withdrew all of the excess
reserves in a very short period of time, a veritable monetary liposuction,
if you will. But a little nip and tuck wasn't going to make the scars of the
error magically disappear. With the monetary base now back to where it
should have been, interest rates are tumbling, real growth is at or near
recession levels, and the Nasdaq, too, is back close to where it should have
been.
'Me Too' Response
The Fed is now doing everything correctly. If it were to once again grow the
monetary base too rapidly our short-term euphoria would come back, at the
risk of long-term inflation and economic stagnation like that of the 1970s.
By maintaining stable, modest growth in the monetary base, the Fed will help
the economy start to recover and secure our longer-term prosperity. In the
meantime, Congress can do its bit by passing a retroactive tax cut to help
stimulate the economy.
The recent fall in the three-month T-bill yield is the natural consequence
of the Fed's remedial actions on the monetary base. The reduction in the
discount rate is simply the "me too" response to the fall in the three-month
T-bill rate. If ever you want to know where the real economic action is
taking place, you'll watch what Moses does with the monetary base.
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