Federal Funds Rate Is Not the Be-All and End-All of Monetary Policy

by: Bob McTeer

Last week I argued that the “considerable period” language in the FOMC’s post-meeting announcements is not a good idea. It robs the FOMC of flexibility it might need, and it gives the markets too much near term certainty. That does not mean that I think the FOMC should tighten monetary policy immediately.

Monetary policy is a broad term having several aspects or components. Not a tightening monetary policy was the eventual consensus regarding the recent increase in the discount rate. After some debate, it was determined to be technical in nature. It was technical, but it also was meaningful. When banks acquire funds in the federal funds market, existing reserves in the banking system are redistributed. When banks borrow funds from the Fed’s discount window, the reserve base of the banking system expands. So, the correct answer to the question of whether the action was technical or a real change in monetary policy is that it was both.

Market participants understand monetary tightening these days to mean an increase in the FOMC’s target for the federal funds rate. However, a constant federal funds rate can be consistent with different growth rates of the money supply, which, if the changed growth rate persists over time, must be considered a change in monetary policy. A casual look at recent M1 and M2 growth charts suggests that monetary policy has tightened of late as their growth rates have declined. We are waiting for the Fed to implement its exit strategy, which we will call a tightening of monetary policy; meanwhile, in terms of money growth, the tightening is already under way, even though it has probably been inadvertent.

While policy has, in effect, already tightened in terms of money growth rates, near zero federal funds rates are probably causing a misallocation of resources harmful in the long run. The markets need positive interest rates to function correctly. Also, the near zero returns on savers’ time deposits causes them harm that must eventually be weighed against the harm of higher rates to investors and other spenders. What I’m getting at here is the need to separate out the various aspects or components of monetary policy so that short-term rates can rise a bit without that constituting a major “tightening” of monetary policy.

Chairman Bernanke should be educating us to the fact that the federal funds rate is not the be-all and end-all of monetary policy and that it can rise modestly within the context of the existing accommodative policy. Not doing so, along with continued use of the “extended period” language, makes the eventual change in the target rate too big and traumatic an event. Baby steps, Ben, baby steps.