/Five monetary policies, by Scott Sumner

Five monetary policies, by Scott Sumner

I recently did an Econlog post trying to explain why it’s misleading to speak of the Fed “controlling” interest rates. I’m not entirely satisfied with that post, so today I’ll make another attempt, from a different angle. I’ll present 5 hypothetical monetary policies, and in each case ask you to consider whether the Fed is controlling interest rates:

1. The FOMC meets every six weeks, and sets an interest rate target to the closest 1/4%.  They instruct their NYC desk to do open market operations as needed to keep interest rates close to the target, although modest intraday fluctuations in the fed funds rate are allowed.  Each six weeks, the FOMC selects an interest rate target that its research staff believes is most likely to lead to 4% NGDP growth.

2. The FOMC meets every single day, and sets an interest rate target to the closest 0.01%.  They instruct their NYC desk to do open market operations as needed at the end of each trading day to keep interest rates close to the target, although modest intraday fluctuations in the fed funds rate are allowed.  Each day, the FOMC selects an interest rate target that its research staff believes is most likely to lead to 4% NGDP growth.

3.  The FOMC meets every single day, and sets an interest rate target to the closest 0.01%.  They instruct their NYC desk to do open market operations as needed at the end of each trading day to keep interest rates close to the target, although modest intraday fluctuations in the fed funds rate are allowed.  Each day, the FOMC selects an interest rate target that an omniscient God tells them is most likely to lead to 4% NGDP growth.

4.  The FOMC meets every single day, and sets an interest rate target to the closest 0.01%.  They instruct their NYC desk to do open market operations as needed at the end of each trading day to keep interest rates close to the target, although modest intraday fluctuations in the fed funds rate are allowed.  Each day, the FOMC selects an interest rate target that the NGDP futures market tells them is most likely to lead to 4% NGDP growth.

5. The FOMC meets every single day and instructs their NYC desk to do open market operations as needed at the end of each trading day to maintain NGDP futures market forecasts of 4% NGDP growth.

In which of these 5 cases does the Fed control interest rates?  Some might argue that the first four cases involve interest rate control, while the 5th does not.  After all, interest rates are not even mentioned in the fifth policy, where there is no explicit attempt to move interest rates to any specific location.

But there’s a problem with this view, as policies #4 and #5 are actually identical, merely described using different language.  If you have trouble seeing this, consider the following analogy:

1. I press the ball of my foot hard enough on the sole of my shoe to depress the car’s accelerator pedal hard enough to achieve a speed of 60 mph.

2. I use my foot to depress the car’s accelerator pedal hard enough to achieve a speed of 60 mph.

Do you see that these are two different ways of describing the exact same action?  The same is true of monetary policies #4 and #5.  One says do enough OMOs to get interest rates to a level where 4% NGDP growth is expected, and one says do enough OMOs to get NGDP expectations up to 4%.  So we can’t draw the line there, and will have to draw the line somewhere else.

I’ll cut to the chase.  In my view the only useful distinction occurs between #1 and the rest of the options.  In case #1, the Fed is controlling interest rates or controlling NGDP expectations, depending on the time frame.  Within a 6-week time frame they control interest rates and let NGDP growth expectations fluctuate.  Over a longer time frame they are stabilizing NGDP growth expectations and letting market interest rates respond endogenously.  In all the other 4 cases, the Fed is simply controlling NGDP expectations and letting interest rates respond endogenously.

So in case #1, interest rates are partly controlled by the Fed and partly endogenous.  Because the long run is far more important than the short run, I’d say interest rates are 5% or 10% controlled, and 90% or 95% endogenous in case #1.  In the other four cases the Fed does not control interest rates; they are 100% endogenous.

PS.  When I read MMT literature I get the impression that they don’t understand these distinctions at all.

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