Does the Fed Really Control Interest Rates?

by: Jake Towne

Many believe that the Federal Reserve controls interest rates. But what if they do not? Here is a case for readers to decide on.

The Federal Reserve, myself, and many others, have made the claim that the Fed controls both the interest rates and supply of dollars and credit. [For those unfamiliar with the Fed, you can learn just about everything you need to know from the links at the bottom of my Federal Reserve plank, and this article "Fractional Reserve Banking in Pictures."] Several weeks ago, I had a conversation with Karl Denninger from Market Ticker on the gold market, and we also discussed his theory that while the Fed can jawbone and could theoretically move the federal funds rate wherever it wants, it still follows the marketplace. In other words, its control of interest rates may be all bluster and a false charade.

Denninger noticed that not only does the short-term 3-month US Treasury bill interest rate overlay with the federal funds rate as seen below, but it moves lockstep and actually precedes volatility movements up or down in the rate. The data and graph can be recreated at the Fed's website here by clicking "Add Data Series" then downloading the data. And a spreadsheet download of the data is here.

However, the graph is too zoomed out to really see the US Treasury interest rate move preceding the Fed funds shift. The below graph zooms in on the last huge downshift from roughly 5% in late 2007. Note the US Treasury drop in the green boxed region precedes the Fed's actions on the federal funds rate.

If Denninger's theory is correct then the Fed is simply following the marketplace that it does in fact influence, through the "injection of liquidity," which is just fancy-talk for printing up new dollars with Bernanke's infamous printing press. When the Fed creates new money, it is at its heart no different than a form of legalized fraud.

A criminal counterfeiter able to create perfect fakes of $100 bills - or electrons in a bank account - depresses the natural rate of interest artificially by placing the bills into circulation, which is the exact same result as when the Fed does it by creating new dollars.

So is the Fed's blustering and jawboning about its "control" of interest rates simply hot air? Does it just print the new money and then monitor the short-term US Treasury interest rates? If so, then the flat-lining at near-zero interest rates for over a year now is even more of a pressing concern as the ship may be sailing without a rudder.

While I won't be so rash as to jump to conclusions, I thought I would instead ask the reader if the above theory makes sense. Of course, in the future if the US Treasury rate increases first and then the Fed follows suit, this will be further evidence of Denninger's theory though at this unique moment in history with interest set at near-zero, who knows what will happen.

What do you think? Feel free to leave your opinion and thoughts below.

Disclosure: No positions