Edward Lotterman
Ho-hum! The Federal Reserve’s policy-setting Open Market Committee met for its eighth and final time this year. It decided to lower its target for extremely short-term interest rates by a quarter of a percentage point, from 3.75% to 3.5%. That minimal change is a cautious compromise that might mollify critics who have been calling for lower rates for months.
Don’t count on it, however. Chief among such critics is Donald Trump. Trump appointed Jerome Powell as Fed chair in 2018, but started lambasting him within weeks of his inauguration. This week’s minimal drop may enrage the president more than please him.
The Fed genuinely faces hard choices. It has a statutory mandate to maintain stable prices. At both the household level and more broadly across many economic sectors, there are indications of prices rising rather than falling. With a two-month gap because of the shutdown, indicator data is thin while the administration is decreeing policies never before attempted.
A pitfall in all of this is that most people don’t understand what exactly a central bank like our Federal Reserve can and cannot accomplish. That includes the president.
What he and, apparently, most journalists, don’t understand is that interest rates for both savers and borrowers largely are set by market forces. Moreover, for both savers and borrowers, there are different amounts of money, lengths of time and degrees of risk involved in financial markets. So there is not just one savings and credit market, but many.
Of course, markets for money do differ from those for beets or pickup-trucks. There is no agency that can create tons of beets out of nothing nor one that sucks thousands of pickups off the market. So while supply and demand are major factors in determining interest rates, the Fed’s money creation and destruction and U.S. Treasury deficits or surpluses also have huge effects. One has to understand both the market-forces and policy-action sides of the equation.
Such actions — the Fed increasing or decreasing the money supply and the U.S. Treasury borrowing smaller or larger amounts — don’t affect all categories of loans equally. If the Fed increases the amount of money available for very short-term borrowing, as it did this past week, that does not necessarily affect availability of money for five-year car loans, 30-year mortgages or even farm operating loans for fuel, seed and fertilizer from April to November. Ditto for the effects of Treasury borrowing via 30-year bonds or 13-week T-bills.
On the monetary side, ballooning the supply of short-term money may increase long-term interest rates if it makes mortgage lenders or others offering long-term money fear inflation. That is precisely the danger today, something Fed policy makers know well even if Trump and many in the media do not.
Decades ago, when Milton Friedman, Nobel laureate, University of Chicago professor and founder of American libertarianism, was still alive, the term “money supply” appeared in most media discussions of Fed policies. Now it almost never does and public understanding of what is going on suffers. Why the change?
The creation and destruction of money involve arcane processes that college students grapple with for weeks. Over the last 20 years, this has become even more arcane. So it may seem easier to just discuss the superficial “the Fed raised – or lowered – interest rates” and ignore the underlying dynamics.
If, however, one wants to understand money creation and destruction, one has to start with actions of the Federal Reserve and other central banks.
The Fed began operating in 1914, about when my grandparents moved to a farm near Chandler, Minn., and opened an account at the state-chartered bank there, where I still hold one also If in the spring Grandpa needed supplies, seed and another horse, he might borrow $400, promising to pay in the fall. So did many other farmers. In spring, the bank might loan out all the fraction of deposits allowed by law.
Then in summer, the local lumber yard might be offered two boxcars of lumber at a good price. People were building barns and houses in 1914. But the lumber wholesaler demanded payment up front and the lumber would be sold only over months. The bank was “loaned up” with no extra cash to lend. What to do?
Well, the Chandler bank now could take promissory notes from my grandpa and others to the new Minneapolis Fed and ask for a loan, presenting these IOUs as collateral. If the small-town bank did not repay the Fed, that new lender could itself collect principal and interest on these retail loans. And, to be safe, the Fed would not loan amounts equal to the collateral presented. Grandpa’s $400 IOU might be “discounted” to $350 actually loaned from the Fed to the small-town bank.
The Fed’s office for such small bank “discount loan” borrowing was the “discount window.” Interest was charged at the “discount rate.” That rate still exists even though such particular lending is largely obsolete.
The key foundation of all of this is that 12 new Federal Reserve District Banks could just create money out of nothing for such loans. Most commercial banks had joined the Fed system and had “reserve accounts” at their Fed. When they borrowed at the discount window, a clerk took a pen and entered “+ $350” in that bank’s account. That’s all.
Nothing came from the U.S. Treasury or anywhere else. “Shazam,” and there it was. But when the Chandler Bank paid off that loan, the money just went “poof” at the Fed and disappeared. The system had provided cash for the economy to operate smoothly over varying seasons, but no one got rich. As another benefit, the Fed could lend money to any small bank when suddenly fearful depositors unexpectedly demanded cash. The bank would not go broke, leaving depositors penniless.
Over the next decade, times when the economy was slowing because of a lack of available loans became apparent, and yet no bank came to the Fed’s discount window. Just as horses may refuse to drink water when led to it and as you cannot push on a string, so banks with borrowing capacity at Fed district banks didn’t always use it to make more loans to customers.
The New York Fed, led by Benjamin Strong, a brilliant and tragic man, discovered another way to increase overall liquidity. It could simply create money, as for a discount-window loan, but instead go to brokers and use the new money to buy U.S. Treasury bonds. The Fed was in an open market with insurance companies, endowment or retirement funds and other private entities buying and selling bonds. By buying bonds, the Fed increased loanable funds in the entire financial system.
When there was too much liquidity, the New York Fed could just sell bonds back to brokers and destroy the money received. This method of increasing and decreasing the money supply thus became known as “open market operations.” It remains the key policy tool a century later.
The FOMC announcing that it is cutting its target for overnight money means that the New York Fed’s “open-market desk” will buy securities with money just created out of nothing. The securities are more complex than they were in 1926. But that must wait for a future column.
St. Paul economist and writer Edward Lotterman can be reached at stpaul@edlotterman.com.
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