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This was the question asked in Niels Jensen’s latest monthly letter that you can read here (pdf). It seems to be a controversial one, but I think the answer is a bit more straightforward than some might think. First, some basics:

  • The Fed is the monopoly supplier of reserves to the banking system.
  • The Fed sets policy based on its expectations of future economic performance (primarily inflation and unemployment levels).

So, if the Fed wants to set rates on government debt then, as the reserve monopolist, it simply challenges traders to a good old fashioned duel. The traders get to try to use their limited money balances to challenge the Fed’s unlimited reserve balances. Said differently, the Fed brings a gun to a knife fight and just starts lighting the traders up. When they get the message that you don’t fight the Fed then they stop trying. The thing is, as the reserve monopolist, the Fed will just set the interest rate on the bonds it wants to buy and good fixed income traders will front-run the Fed there. So if the Fed wanted to set the 10 year bond at 1% then it would announce a 1% target and if the rate didn’t go there then the SOMA desk would start shooting people who are challenging it with knives. The rate would go to 1% on the 10 year.

Now, the more interesting variable here is the economy. The Fed can control the interest rate on its debt, but it can’t necessarily control the economy. So, what happens if the Fed sets a 1% target on the 10 year bond and the economy starts picking up a huge amount of steam and inflation starts to pick-up? Well, then it becomes a policy game. Does the Fed keep the rate where it wants thereby inducing more potential inflation? Or does the Fed react to the changing economy and tighten policy? That depends on what the Fed wants to do, but it should not be controversial that the reserve monopolist could keep the 10 year yield at 1% even in the case of a very high inflation. It would probably be counterproductive to do so, but it should not be controversial.

The bottom line is, as the reserve monopolist the Fed can control the rate on US government debt, but it cannot necessarily control the economy. So to me, the more interesting question is not whether the Fed can control interest rates (it can), but whether it can actually control the economy. I would argue that the last few years prove that the Fed can have an enormous impact on the economy, but it cannot necessarily control the precise direction of the economy.

Source: Can The Fed Actually Control Interest Rates?