A couple of days ago, Phil, a reader of this blog, left a comment challenging my view that a "central bank has far less control of the economy" than many assume. I want to present a view that is completely radical that it may alter your thinking. This blog might be the worst investment blog known to man ;) but hopefully I make you think (but do note that I can be wrong.) I didn't come up with the idea I'm about to present (I'm just repeating others' views) but it completely changed my thinking a few years ago. In fact, it altered my view so much that, these days, I don't believe a central bank can "save" an economy no more than it can "boost" the economy (in the long run.) None of this is to say the central bank is useless—indeed, it plays a very powerful role, as many Keynesians would suggest, when it acts as a lender of last resort (usually during wars or economic calamities)—but the vast majority of the time a central bank really doesn't control much.
Before I present the view, I should make some exceptions. Central banks are very powerful under totalitarian regimes. So none of this applies to them. In addition, what follows probably doesn't apply to central banks that do not follow "modern" (developed-world) economics or are based on some "primitive" economic systems. For instance, I am sure that none of what I say applies to the central bank of Afghanistan (assuming it even exists.)
The Federal Reserve You Never Knew
Probably almost everyone reading this probably assumes that the a central bank, like the Federal Reserve in America, controls the short-term interest rate. Many would have grown up thinking that the central bank directs the economy. I'm going to present some information that challenges that view.
In article challenging the influence of the Federal Reserve—a highly recommended read for those who are macro-oriented—John Hussman had this to say:
(Note: The bolds in the quote are by me; Hussman's original comments also contains bolds but they are not reproduced here. If you do read the full piece, keep in mind that my post is dealing with a narrow topic, short-term rates, whereas Hussman's article is talking about the FedRes in general.)
The main job of the Federal Reserve is to determine the mix of government liabilities held by the public. When the Fed "eases monetary policy" or "cuts interest rates", it accomplishes this as follows. The Fed goes into the open market, buys a bunch of Treasury securities from banks (who have drawers full of them), and pays for them by creating new bank reserves.
When the Fed "cuts interest rates", what it is really doing is replacing one government liability held by the public - Treasury securities - with another government liability: currency and bank reserves (monetary base). That's all the Fed does. It determines the mix - but not the total amount – of government liabilities held by the public. Since the operations of the Fed are executed by buying or selling securities on the open market, the group at the Fed responsible for these decisions is called the Federal Open Market Committee, or FOMC.
Essentially, the Fed lowers the Federal Funds rate by purchasing Treasuries from banks and increasing the "monetary base" - bank reserves plus currency in circulation. The only thing that the Fed can control with certainty is the monetary base. Alternately, it can try to control the Federal Funds rate (and passively adjust the monetary base by whatever amount is required to keep Fed Funds on target). However, the Fed cannot control the Federal Funds rate with certainty. For example, if inflationary pressures were high and interest rates were moving up, the Fed could not predictably lower the Fed Funds rate by easing monetary policy. Not surprisingly, central banks always target money growth, not interest rates, when inflation is high. That's why Volcker targeted money supply, while Greenspan targets interest rates. But ultimately, the only thing that the Fed can directly control is the monetary base.
Except for the Federal Funds rate, the Fed does not determine short-term interest rates. Most of the time, it simply follows them. Statistically, the Federal Funds rate consistently lags market interest rates such as Treasury bill yields. Indeed, changes in market rates have far more predictive power to forecast the Federal Funds rate than vice versa.
The main exception is the Prime Rate. Changes in the Prime Rate follow changes in the Federal Funds rate largely because 1) competition forces equality of lending rates; 2) the Fed Funds rate tracks other short term rates, and; 3) changing Prime in unison at any other time than a discrete Fed move would be considered evidence of collusion among banks.
Admittedly, economics is the dismal science and some may dismiss John Hussman's views as being too outside-the-box thinking and possibly erroneous. But before you dismiss his views, at least think about them.
John Hussman says that the Fed Funds Rate, which is the only short-term rate the FedRes controls, lags the market rates. Is this really true? I was shocked the first time I saw a chart like the following (chart courtesy Robert Folsom of ElliottWave.com):
The same picture is also true in the longer run. The following chart by Tim Wood apparently illustrates it (admittedly it is very hard to see from the picture):
It's really hard to see from that chart but you just need to believe me when I say the Fed Funds rate follow the market-controlled t-bill yield—either that or you need to go and do your homework. If you drilled into a narrower time frame in the chart above, you'll essentially get a chart like the first one, with the Fed Funds rate following the t-bill yield. It's not always perfect and things like wars may alter the relationship somewhat but, in the grand scheme of things, the FedRes rate lags the market.
What Happens If the FedRes Raises Rates to 12%?
Phil rhetorically asked what happens if the FedRes jacks up the shot-term rates to 12%.
In the short term, anything can happen. I wouldn't debate anyone's view that the cost of debt, for instance, would be really high initially.
In the long run though, my view is that it would not contract (or cool) the economy as much as many would assume (the actual result depends on a whole hoard of other factors.) I'm not an economist or a financial expert but my guess is that, if the market rate was lower, the free market would bypass the central bank. Borrowers may borrow in foreign lands at lower rates; or lenders may charge lower rates even though the FedRes is keeping rates high. If you want to see how this can happen, consider the opposite case.
What happens if the central bank sets rates really low while the market prices it much higher? Well, we just need to look around because this scenario is pretty common (governments don't mind setting rates low but don't like high rates (the original scenario above.)) There are many countries, usually in the middle of a crisis, who do that. I have to double-check the numbers but I believe Argentina in the early 2000's, Brazil in the 90's, Zimbabwe in the late 2000's, among numerous others, have done that.
In the very extreme case of Zimbabwe, you had the central bank essentially dictating a really low rate while the free market was pricing in very high rates. In practical terms, this basically meant that the government would loan you money at fairly low rates while private investors demanded very high rates (no one would be caught dead loaning money at low rates while the hyperinflation beast is running all around your neighbourhood.) In the end, the economy ended up, in some sense, bypassing the central bank. What the central bank did had little influence. No private citizen or business would freely loan you money at low rates even though the central bank was trying to maintain a low rate (countries like Zimbabwe heavily regulate, usually be arbitrary jailings, beatings, and stealing (taxes) so what I am saying may not be the public view of the lenders i.e. no one would freely lend you money at low rates but some would have because of government threats.) In any case, the point here is that the central bank had very little control even though it was a democratically-elected totalitarian government with greater control than USA.
I believe a similar thing, with the market bypassing the central bank, would materialize in the original scenario of 12% rates. I don't have any proof of it but I do think the central bank would lose even more power if it priced its rate at a high level while the market prices it much lower.
How About Long-Term Rates?
So far we have dealt with the interest rate that is generally under the most direct control of a central bank: the short-term rate. How about the long-term rate?
Well, again, I'm not an economist but I don't think the central bank has much influence over long-term rates either.
First of all, they generally have even less control over the long-term rate. At least the central bank "sets" the short-term rate whereas the long-term rate is generally under the control of the market (essentially bond buyers.)
The only way the central bank controls the long-term rate is to go out and buy (or sell) government bonds. This generally involves printing money and buying long-term government bonds with that money (it's called monetization and, all else being equal, results in inflation.) Outside of some crazy scenarios (usually involving war) central banks can only influence, indirectly, the long-term rates. Even then, the rates don't move much because the long-term debt obligations are very large and you need to spend hundreads of billions (or possibly trillions over a period of time) to do much.
So, I don't believe the central banks control the long-term rates so they aren't very powerful on that front either. However, if they do manage to control the long-term rates, they will be really powerful. At times, they have done that (usually during wars (eg. America during WWII) or when acting as lender of last resort (eg. when no one wants to lend money (like in the last 2 years)) but those don't last.
So to sum up, central banks aren't as powerful as they appear. Their most direct control is the short-term interest rate but even with that, they generally follow the market rate. I think a lot of people probably think a central bank is powerful because their daily dealings revolve around the prime rate, which essentially follows the Fed Funds rate (as John Hussman pointed out above.) If you buy a home or a car, it is driven primarily by the prime rate so I can see why people think central banks are powerful. After all, when the FedRes cuts rates, the prime rate drops almost instantly and people think the central bank has a lot of power.
The way I look at it, central banks are weak most of the time. However, their power is inversely correlated—yes, I made that up but believe it's true—to the severity of a crisis. The worse an economic crisis is, the more powerful central banks are. This is mainly because of their ability to act as a lender of last resort, ability to print money at will, and the legal power to heavily regulate financial institutions and (in some cases) capital market transactions. Tags: economics, John Hussman