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The Fed Funds Rate Is Meaningless

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A month ago, the world waited with bated breath in anticipation of the Fed’s increase in the fed funds rate of 25 basis points. This week Larry Summers, former U. S. Treasury Secretary, solemnly questioned whether “the world economy could comfortably withstand four hikes” in the fed funds rate during 2016, which was the consensus forecast of the FOMC members at their last meeting. These hikes are expected to total about 1 percentage point bringing the fed funds rate to 1.375 percent.

Summers argues that the slowdown in China and the related slump in oil and other commodities as well as  the problems afflicting emerging markets have resulted in a world that is “demand short,” in Keynesian jargon.  This requires, according to Summers, that the U.S. stand ready to implement expansionary monetary and fiscal policy in order to avert a global meltdown.

Now, Summers’ appeal to fallacious Keynesian analysis aside,  the recent increase in the fed funds rate and the series of expected  rate boosts mean exactly nothing for the U.S. or the global economy—and not just because of their minuscule size.  Movements in the fed funds rate in themselves have almost no influence on other interest rates, let alone on other important economic variables such as investment, employment, inflation, or total output.  The reason is that the market for federal funds is an artificial market created and driven by the Fed in which banks trade reserves among themselves.  Under the classical gold standard, a stock of reserves was a self-imposed prudential restraint on credit expansion by individual banks.  In the modern fiat-money era, reserves are nothing more than digital licenses to print money issued by the Fed to cartellized fractional-reserve banks who use them to expand credit and create money in the form of demand deposits.

By virtue of open market operations, its statutory control over reserve requirements and the discount rate, and its recently acquired authority to pay interest on bank’s excess reserves, the Fed exercises nearly absolute control over the “price” of bank reserves—which are created in cyberspace by the stroke of a keyboard.  The fed funds rate is therefore a phony price set by the arbitrary whim of bureaucrats and it has almost no direct effect on the determination of interest rates on overall credit markets.   Furthermore, the fed funds market is a tiny part of the total credit market in the U.S.  For example, from July 2014 to April 2015 the average daily number of transactions in fed funds was a paltry 300 and the average daily volume of overnight funds traded was $50 billion.  This was dwarfed by bond market transactions in the U.S., whose average daily volume of trades for 2015 through October was $740 billion.  And this figure does not take into account the daily volume of transactions in the market for loans issued by banks and other financial intermediaries.

This is not to deny that the Fed powerfully affects the U.S. economy by conjuring new bank reserves out of thin air and injecting them into the banking system via open market operations.  By lending out these new reserves to businesses and households, banks are able to create demand deposits unbacked by reserves, or so-called “fiduciary media.”  In this way fractional-reserve banks generate a multiple expansion of the money supply on the base of “high-powered” fiat money created by the Fed. The Fed’s “targeting” i.e., manipulation, of the fed funds rate is a deliberately arcane technique for using open market operations to create bank reserves to expand the money supply.  Movements in the fed funds rate are an incidental effect in this money creation process.  The Fed could just as easily drive the money creation process by using open market operations to directly target the average price of a commodity basket or a selected stock market index or the exchange rate with the Euro or any other nominal variable that it chooses.

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.  These inflation-fueled malinvestments result in bubbles in real estate, commodity, and financial markets and a distortion of the real structure of production that invariably culminate in financial crises, unemployment and recession or depression.

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 by clueless Fed technocrats whose budget and policy decisions are not subject to Congressional oversight and control.

As for Larry Summers' hand wringing over the prospective “tightening” of Fed monetary policy in a “demand short” world: it is in vain.  For as the graph here illustrates, from a crudely empirical standpoint, there is no systematic relationship between movements in the fed funds rate (blue line) and movements in the monetary growth rate (red line).
 

In other words, since 1990 the Fed's boosting of the fed funds rate has not often been accompanied by a reduction in the growth rate of the money supply.  As I have argued above, theoretically, increases in the fed funds rate are perfectly consistent with a higher rate of monetary growth.

Joseph Salerno is academic vice president of the Mises Institute, professor of economics at Pace University, and editor of the Quarterly Journal of Austrian Economics.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.
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