When your only tool is a hammer
…you tend to see every problem as a nail” as the saying goes but what exactly does this mean when commentators apply it to monetary policy? While the “nail” in this phrase is inflation which, as we’ve discussed, requires specific measures to find, the “hammer” in this saying is less clear. Interest rates play a role, but how they currently function has changed drastically since the Great Financial Crisis.
The Fed’s main tool for conducting monetary policy is the Federal Funds Rate or the interest rate at which depository institutions pay for overnight borrowing in the Federal Funds Market. As interest rates “rise” the Fed aims to keep the daily effective federal funds rate, or the daily volume-weighted median rate of all overnight federal funds transactions, in the FOMC’s target range. Previously, the Fed would use daily open market operations to buy or sell government securities to increase or decrease the supply of reserves in the banking system. This ‘limited reserves’ framework changed completely as the level of reserves in the banking system ballooned following the financial crisis. It is in this context that the ‘ample-reserves’ approach emerges. While the Federal Funds rate is still its primary tool, the Fed’s primary tool to adjust it is the interest on reserves (IOR) and the overnight reverse repurchase agreement rate (ON RRP). In tandem, the IOR is the main way the Fed sets the Federal Funds Rate and affects short-term interest rates as banks have little incentive to lend reserves at rates lower than the IOR while the ON RPP acts as a supplementary tool for financial institutions that do not have access to the interest paid on reserves.
In turn, the Fed has essentially complete control over short-term interest rates with the pass-through of policy rate hikes and cuts tracking the Federal Funds Rate consistently. That said, long-term interest rates are more ambiguous. This is because long-term interest rates are set largely by factors that the Fed has only delayed and indirect control over. This is why some argue that long-term rates are what the Fed follows rather than it being the other way around. In either case, they are integral to Powell’s current goal. As he stated on February 1st, “Our overarching focus is using our tools to bring inflation back down to our 2 percent goal and to keep longer-term inflation expectations well anchored”. Crucial here is that the longer inflation remains elevated, the more likely expectations become unanchored. This is why the hammer analogy misses a key part of the picture - not only is it about finding the nail and having a hammer that is constructed properly (measuring inflation and how the FFR is adjusted), but it’s equally about conveying to people that your hammer is big enough to do the job!
This dynamic of long-term interest rates is conveyed best in an example from Paul Volcker explaining the importance of expectations in an interview in 1982:
“That's the basic trouble with the gold-standard thing -there are lots of technical troubles, but the trouble with that argument is: Great, we're going on the gold standard, so 30-year bond rates are going to go down to 5 percent because investors know we're on the gold standard. But they know much more than that! We went off the gold standard 10 years ago, and when you're looking at a 30-year bond…”.
This applies to Powell. In three years' time, he very well could say that inflation was vanquished; the problem, of course, is if he had prematurely said the same thing before. As Volcker's quote finishes: “You know, once you've bit the apple, you can't say you haven't left the Garden of Eden.”
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