Wednesday, July 25, 2012

Who Cares about Fed Funds?

Copyright, The New York Times Company

New research confirms that the Federal Reserve’s monetary policy has little effect on a number of financial markets, let alone the wider economy.

Politicians, and a few economists, have been imploring the Federal Reserve to help the economy grow before November. But the effects of monetary policy on the wider economy are small.

The Federal Reserve and especially its regional bank in New York are actively engaged in buying and selling Treasury securities, and the Fed lends money to banks. These transactions influence the rate charged on overnight loans among banks, which is known as the federal funds rate.

Because interest rates are important to homeowners and businesses, it is tempting to conclude that the Federal Reserve affects the economy by affecting interest rates. But the federal funds rate is only one of many interest rates in the economy, and it is those other interest rates that households and nonbank businesses pay as borrowers and receive as lenders.

Yet a few economists have concluded that today’s exceptionally low interest rates on federal funds have turned our economy upside down, so that policies like unemployment insurance that pay people for not working these days actually get people back to work.

A 1983 study by Lars Peter Hansen of the University of Chicago and Kenneth Singleton of Stanford showed that short-term rates on Treasury bills and short-term returns on stocks traded on the New York Stock Exchange had very little correlation with consumer spending. Many empirical studies have confirmed this sort of result (this comparison of inflation-adjusted Treasury bill returns and business sector profitability is a recent example).

Nevertheless, a few economists working on the relationship between short-term interest rates and the economy still assume that consumer spending closely follows those rates (see, for example, the bottom of Page 5 of this paper). Their assumption can be useful for exploring other issues, so long as we keep in mind that the close relationship between short-term interest rates and consumer spending is their assumption, rather than a conclusion or an empirical finding.

For a number of reasons, consumer spending, growth of gross domestic product and other important indicators of economic activity might be weakly correlated with the federal funds rate. For one, much economic activity — such as the many employees working for small businesses — occurs separately from financial markets.

It is also easy to exaggerate the linkages between various financial markets. Eugene Fama of the University of Chicago recently studied the relationship between the markets for overnight loans and the markets for long-term bonds. He found that Federal Reserve policies had an obvious effect on the federal funds rate and perhaps also on rates on commercial paper (the market for large short-term loans to businesses).

But Professor Fama found the yields on long-term government bonds to be largely immune from Fed policy changes.

For all these reasons, the right explanation for the failure of our economy to rebound from the 2008-9 recession lies far beyond the market for federal funds.

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