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The Wicksell Club

November 26, 2015

I was pleased to see David Henderson call out Bill Poole for claiming the Fed sets the federal funds rate. It doesn’t, of course. Welcome to the Wicksell Club, David! We don’t have ties or t-shirts. But our common cause is worthwhile.

Many of my economist friends get annoyed when I insist they refer to setting the federal funds rate target (as opposed to setting the federal funds rate). They know that the Fed is not literally setting the federal funds rate; that the rate is determined by suppliers and demanders in the overnight market; and that the Fed, as Bernanke has made clear, has a limited influence on even short term rates. But, they maintain, it is a convenient shorthand of little consequence.

I disagree. Perhaps I have spent too much time in a liberal arts environment, but I believe the language we use matters. In this case, the dominant Fed-sets-rate language makes it easy to assume that the federal funds rate is low because the Fed’s target is low. It makes it difficult to even consider the possibility that the Fed’s target is low because the market-clearing federal funds rate is low. Moreover, it suggests the Fed is in a direct and dominant position when, in fact, the Fed plays an indirect role and, at least by my assessment, is subservient to routine market forces. It also seems to perpetuate the all-too-common error of associating low rates with expansionary monetary policy and high rates with contractionary monetary policy. (Scott Sumner is right: Interest rates are not a reliable indicator of monetary policy.) How can we consider whether the Fed should adjust its target rate if we fail to recognize the natural rate?

There are consequences to sloppy thinking. And sloppy language encourages sloppy thinking. So keep fighting the good fight, David. May our club’s membership swell.

One Comment

  1. Tormeti December 22, 2015 4:27 AM

    is this fair – instead of the Fed – suusittbte the Obama Admin.Re-writing the James Hamilton piece on the role of the fed”Some have criticized Obama’s economic policies (the Fed’s emergency lending) on the grounds that he (the Fed) took all these extraordinary actions and yet the economy still performed very badly in 2008:Q4 – 2009:Q2. I think this misses the point. I don’t believe that it was ever within Obama’s (the Fed’s or anyone else’s power) to bring the economy quickly back to full employment. Instead, the purpose (of the Fed’s emergency lending) was to prevent a very bad situation from becoming even worse than it needed to be. The evidence we now have suggests that he (the Fed) indeed accomplished exactly this. My view is that the Obama administration (the Fed) never had the power, and lacks the power today, to solve our primary economic problems. However I believe he (it) did have the power, and successfully exercised the power, to prevent our problems from becoming even worse.”In this view Obama’s sin was over promising, not policy error.