When people talk about “the Fed raising or lowering rates,” what are they really talking about? Does the Federal Reserve — the US central bank — really have the power to control interest rates throughout the US economy?
Interest Rates
The concept of an interest rate is simple. An interest rate is essentially the price of money — an amount a lender charges a borrower for use of capital — determined by time preference. There is the low time preference of the lender (willingness to sacrifice present savings/consumption for future gains) and the high time preference of the borrower (willingness to sacrifice future savings/investment for immediate consumption).
In other words, an interest rate is a signal to the market of the extent people desire to save/invest for the future vs. consume for the present. Preference for immediate access to money comes at a cost (i.e., an interest rate).
So, you can see that with a low time preference, economic growth is made possible because an increase in savings and investment occurs at the sacrifice of immediate consumption. As time preference falls (immediate demand for money falls), interest rates fall along with it. And vice versa occurs with a high time preference — an increase in the immediate demand for money causes interest rates to rise.
An interest rate provides a signal to entrepreneurs indicating the best use of that capital. In a normal world, a low interest rate signals that there are ample resources available (a high supply of capital) to invest in projects. But we are not in a normal world; we are living in Fed-world.
When the Fed creates money out of nothing and injects it into the banking system, it expands throughout the economy like a pandemic and distorts the reality of the market. The expansion of the money supply sends a false signal that ample resources are available when in fact they are not. Let’s see how they do this.
The Federal Funds Rate
We all know from experience that local banks and lenders offer varying, competing interest rates. We sometimes shop around to get the best rate when taking out a loan or financing a purchase, such as a car or house. So, is it really accurate to say the Fed controls the interest rate?
Now, it’s obvious that the Fed does not directly control every single interest rate in the market. But, it is true that the Fed sets a target rate at the highest level via the federal funds rate.
The federal funds rate — also known as the overnight rate — is a target rate at which commercial banks borrow/lend their excess reserves to each other, literally occurring overnight. Bank reserves fluctuate daily based on lending, deposit, and withdrawal activities. These overnight operations help to square-up any shortage or surplus of cash a bank might have at the end of the day to satisfy their minimum reserve requirements.
A higher overnight rate makes it is more expensive for banks to square-up, so theoretically banks will compensate by raising their own rates (e.g., mortgage rates). In this way the federal funds rate can influence market rates indirectly.
But, how much influence does the federal funds rate really have? Economist Joseph Salerno calls it a “sideshow” and points out that the real influence on the market comes from the Fed’s power to create money out of nothing.
“The targeted variable and its targeted level are not important per se. It is the increase of bank reserves and the resulting expansion of the money supply when banks loan these reserves out that artificially reduces market interest rates and misleads entrepreneurs and capitalists into investment decisions that result in malinvestment and overconsumption. … The lesson here is to realize that the hoopla surrounding movements of the fed funds rate is a sideshow intended to distract attention from the main event: the arbitrary and pernicious manipulation of the money supply …”
If we look at the relationship between money supply (M2) and the federal funds rate over the last two decades in the chart below, it is evident that an increase in the federal funds rate does not correspond with a decrease in money supply growth.
Well then, what’s the point of the federal funds rate if it has no measurable impact on money supply? Is Salerno right? Is it really just a sideshow?
How is the Money Supply Increased?
The real magic of money creation happens in what the Fed calls “open-market operations” coupled with the regulation of bank reserve requirements.
Bank Reserves
Banks don’t maintain 100 percent of the money that people deposit. They only keep a fraction on hand. In other words, if a bank has $10 million deposited within it, it is legally obligated to only maintain a fraction of those deposits as reserves. Back in the good ol’ days, as Grandpa would say, these reserves took the form of gold and silver. So, if everyone decided to go withdraw their money and redeem it for their gold and silver at the same time (aka, a bank run), well there’d be a problem. The money is not all there.
The reserve requirement used to be 10%, so 1 out of 10 people may have gotten lucky. But recently, the Fed has set the reserve requirement to zero. Yes, that’s right — zero.
Why does this matter? Bankers lend out money to make money. The more money they can lend out, the more money they can make. The lower the reserve requirement, the more available money they can lend out.
What’s that you say? The banks are lending out money that isn’t there? Yes, that’s right. Think about that. This is how the money supply is expanded exponentially throughout the economy.
Open-Market Operations
The Fed explicitly targets a particular federal funds rate by engaging in what they call “open-market operations.” Essentially, the Fed regulates the supply of money in the banking system by purchasing (or selling) assets like securities on the “open market.” The Fed simply writes a check against itself, effectively creating money out of nothing (they can remove money from the system in the opposite manner by selling assets to the market and soaking up the cash). This new money is often deposited into the banking system in the form of reserves. The “experts” claim this promotes growth, but really this is simply just the act of enriching those who touch the new money first.
This artificial increase of bank reserves results in an exponential expansion of the money supply because banks turn around and expand loans from these reserves out to the market. When the Fed lowers the required reserve requirements, the effect only gets worse. Think about if $10 million was deposited into a bank from the Fed. If the reserve requirement was 10%, then the bank could now turn around and lend out $90 million to the market — $90 million that didn’t exist. The initial $10 million injection from the Fed turns into a total increase of $100 million in reality. This is the exponential effect of fractional-reserve banking. And if the there is no reserve requirement, the banks can lend out whatever their hearts desire.
Money Supply and Interest Rates
This injection of new “money” results in an artificial reduction in market interest rates. It distorts the reality of the extent of true capital/savings available and influences people’s time preference. The abundance of money in the system gives a perception that there is an abundance of wealth and resources. But this is a facade that only confuses and misleads entrepreneurs and capitalists into poor investment decisions that result in overconsumption.
These poor investment decisions result in bubbles in certain sectors of the economy that inevitably result in financial crises once it is realized that the resources really aren’t as available as originally perceived.
So, back to the original question — “Does the Fed really control interest rates?” We see that the federal funds rate establishes a baseline rate upon which commercial banks base their lending rates. So, a rise or fall of the federal funds rate will certainly drive a corresponding rise and fall of market rates.
But, perhaps the main driver of market interest rates is the ability of the Fed to manipulate the money supply and thereby trick the market into thinking that the economy is healthy and full of capital when it is not.