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.

Who Cares About the Fed?

Copyright, The New York Times Company

Short-term interest rates have an obvious effect on the housing market, but not the rest of the economy.

Federal Reserve policy affects short-term interest rates, bank regulation and eventually inflation. I will write about inflation next week, and my fellow Economix blogger Simon Johnson has written much about bank regulation, so today I focus on short-term interest rates.

The Federal Reserve, especially its New York branch, is actively engaged in buying and selling Treasury securities, and it lends money to banks on an overnight basis. As a result, it is widely thought that the Federal Reserve is an important determinant of the rate of interest paid on short-term Treasury securities.

By raising the supply of Treasury securities and reducing overnight lending, so-called “tight” monetary policy raises short-term interest rates. High short-term interest rates are said to discourage borrowing, and thereby curtail private sector investment projects. The idea is that private sector projects are undertaken only when their expected return exceeds the cost of borrowing.

In theory, high short-term interest rates result in relatively few capital projects, with high expected returns, and low short-term rates result in more capital projects, including those with lower expected returns.

But the effect of high short-term interest rates on Main Street’s economy has been exaggerated. Although it is commonly assumed that today’s rock-bottom rates should help strengthen a business recovery, it appears that business conditions actually have little to do with short-term money markets.

Many important private sector investment projects are relatively long term — it most likely takes a year or more for a project to be completed and deliver a positive cash flow to investors. As a result, many capital projects are financed through long-term borrowing, with equity financing, or out of corporate retained earnings, rather than borrowing in the short-term market where the Fed’s fingerprints are so obvious.

In theory, long-term interest rates could rise as the Fed tightens the short-term money market, because some savers would be on the margin of saving in either the short- or long-term markets. Equity capital markets and retained earnings could, in theory, also be subject to similar indirect effects.

Thus, the effects of Federal Reserve interest-rate policy on investment are indirect, and it is an empirical question as to whether the expected effects — tight money discourages investment projects — are significantly reflected in preventing capital projects with low expected returns.

Luke Threinen and I have measured national average profitability of capital projects from the national accounts by dividing total interest and profits in the economy during a year by the total capital stock in place at the beginning of the year. In doing so, we have distinguished residential capital (i.e., houses) from business capital.

Capital produces value over a number of years. In the case of housing capital, the value is in the form of shelter and the convenience of a home. For any piece of capital, profitability (capital’s marginal product, as economists call it) can be calculated as the dollar value it creates during a year — after subtracting depreciation, costs of labor, maintenance and intermediate goods — per dollar invested.

Owners of capital prefer their capital to be more profitable, rather than less. It’s the profitability of capital (after taxes and subsidies; more on those below) that makes an owner willing to purchase capital in the first place.

Chart 1 compares the profitability of housing capital to the inflation-adjusted return on one-year Treasury bills (for comparability with T-bills, housing profitability is adjusted for property taxes). Consistent with the view that tight monetary policy both raises Treasury bill rates and reduces housing investment, the two series are positively correlated. The home-mortgage market appears closely linked, so high Treasury bill rates cause banks to charge more for home mortgage loans, which discourages homeowners and landlords from building homes unless the demand for homes is sufficient (i.e., landlords can earn enough rent from their tenants to cover a high mortgage rate).

Among other factors, easy credit from the Federal Reserve in the early and mid-2000s made it easy to buy and build homes, and as the inventory of homes grew the amount of rent that each home could earn (many homes went vacant, for example) fell, which shows up in Chart 1 as especially low values for the red series. In this way, the housing cycle of the 2000s confirms the usual story about how monetary policy can affect housing investment.

The usual story about Federal Reserve policy and business investment says that a similar process works on the business sector: High Treasury bill rates cause banks to charge more for business loans, which discourages business from investing unless demand for their product is sufficient (i.e., businesses can earn enough profit from their operations to cover a high loan rate).

Our findings for the business sector are quite different from the usual story. Chart 2 compares the profitability of business capital to the inflation-adjusted return on Treasury bills, and the correlation is negative.

One way that easy monetary policy could hurt business investment is by encouraging home-construction activity, and home construction takes resources away from business construction.

The evidence in Charts 1 and 2 suggests that the housing market can be stimulated by easy monetary policy, at least in the short run. But the link between monetary policy and the business sector is much weaker, and our data are consistent with the view that, holding constant the rate of inflation and the amount of banking regulation, monetary policy does not have a discernible effect on the cost of business capital.

The Optimum Quantity of Money, 2010

Milton Friedman's Optimum Quantity of Money rule said that government liabilities (of which "money" is one example) should by supplied in large enough quantity that they earn the same return as private sector liabilities.

Today it was reported that now U.S. Treasuries yield about the same as some high grade corporate debt, after decades of yielding significantly less. Berkshire Hathaway debt actually yields less (but see the comment below that Bloomberg made a mistake)!

Unfortunately, Milton Friedman and economists since him do not have an empirically accurate theory of why private sector securities have such different expected returns, so it's not clear which of the many private returns would be the same as the Treasury yield in a world with the optimum quantity of government liabilities. Is the average private return? Or the returns on private securities with similar "risk" as Treasuries?

The answer depends on what is your theory of why private assets can have different returns, but arguably we have now reach the optimum quantity of government liabilities.

Old Money

In monetary theory, we assume that fiat currency can be supplied at zero marginal social cost, because the costs of paper and ink are negligible compared to the value of the paper commands as currency.

The Alaskan economy offers a slight deviation from that assumption. Of course, they use U.S. currency. But the nearest federal reserve bank is in San Francisco (although that district has a Seattle branch). And much of Alaska is far from a commercial bank branch.

All of this must mean that it is expensive to replace old currency with new, at least through the normal bank-system-channels. So the currency they use is old and quite worn!

I should insist on a discount from merchants who receive the crisp bills I brought from IL and/or make me change with worn bills that I'll bring back to IL.

Market arrangements like these would help solve the problem of supplying crisp currency to Alaska.

I'll let you what the AK merchants think of my theory!