Monetary policy is about money, not interest rate

FFederal Reserve watchers are stunned by the proposed central bank tightening.

Following the recent Federal Open Market Committee meeting, Federal Reserve officials confirmed that they plan to put the brakes on. The balance sheet could even contract in summer. We could just go back to normal monetary policy, something that has not been discussed since COVID-19 nor seen since the 2008 crisis.

Unfortunately, the switch to regular ordering comes with some baggage. There is one mistake that financial and economic commentators seem determined to make: the idea that the Federal Reserve is “fixing” interest rates. We cannot escape the misdeeds of money until we put this mistaken view behind us. Interest rates can be useful as a barometer of monetary policy. They give policy makers clues about liquidity conditions. But don’t confuse the barometer with the weather.

The Federal Reserve is targeting a range for the federal funds rate – what banks charge each other for overnight loans. Like most interest rates, this price of leased capital is determined in a market. The Federal Reserve is an important player in this market but does not control it. Yes, the Federal Reserve can influence the federal funds rate by changing the supply of bank reserves. But policymakers cannot do whatever they want with this rate. Long periods of low interest rates, as we have now, are due more to market forces than to the will of central bankers.

If we don’t understand how monetary policy works, we are likely to be wrong in deciding whether money is loose, tight, or fair. The difficulty is due to the many effects of changes in the money supply on interest rates. Cash injections can lower short-term interest rates by increasing the supply of loanable funds. But the longer-term effects work the other way around: increased output and inflation pushes interest rates up. High rates can mean loose money and low rates mean tight money. It reverses conventional wisdom.

An excessive focus on interest rates is dangerous. Instead, we should pay attention to what really matters to monetary policy: the money itself. It all depends on supply and demand. Money is loose if its supply exceeds the demand to hold it; money is tight if its supply is less than the demand to hold it. The price of silver, its purchasing power, adjusts to balance supply and demand. It’s the old school monetarist paradigm. Although it has been updated and extended since the days of Milton Friedman, the basic idea still holds. The corollary is that interest rates are irrelevant. Creating and circulating money is what matters.

This is not an ivory tower chicane. Monetary history is replete with political failures, many of which stem from a misunderstanding of interest rates. In the 1930s, the Federal Reserve turned a large, but not fatal, market correction into the Great Depression by failing to counter a plummeting money supply. Why? Because interest rates were low, policymakers mistakenly thought the money was already in bulk. The contemporary version of this mistake is the “liquidity trap,” the belief that the Federal Reserve is out of ammunition when interest rates hit the “lower limit of zero.” Absurdity. As long as there are assets to buy, the Federal Reserve is never powerless.

As the Federal Reserve unwinds its emergency policies, we must beware of the reverse error. Growth in output and inflation will eventually lead to higher interest rates. This is a sign of a booming economy, not of sagging. The Federal Reserve’s target rate hikes should be understood as following broader market conditions rather than determining them.

It has been a tumultuous decade for monetary policy. With the fallout from the 2008 and 2020 emergencies behind us, we are ready to bring the central bank back to the realm of the ordinary. Our difficulties will not be unnecessary as long as we remember this crucial lesson: Economic stability depends on the supply and demand of money, not on interest rates.

Alexander William Salter is Associate Professor of Economics at Rawls College of Business, Texas Tech University, Research Fellow at TTU’s Free Market Institute, and Principal Investigator at AIER’s Sound Money Project.

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