Scott Sumner writes, among other things,
there is utterly no reason to presume that “the financial markets will evolve ways to insulate the economy from what the Fed does.” Indeed so far as I know no economist has ever even proposed a model where this is true. And that’s because it would have to be a very strange model.
This puts me in an awkward position. Either I say that this is my own model, in which case I think I am taking more credit than I should. Or I say that it is implicit in the writings of some other economists, in which case Scott is going to argue that I am misinterpreting them. When in doubt, I will commit the first error.
However, I am not totally daft. Jeffrey Rogers Hummel has just posted an excellent tour of monetary theory. It serves as a very useful reference. Read the whole thing. He concludes,
As I conceded at the outset, central banks can affect interest rates somewhat. What is incorrect is the now-common but simplistic belief that the liquidity effect is so powerful that it allows the Fed to put interest rates wherever it wants, irrespective of underlying real demands and supplies in the economy. Nor do I deny that central banks have other far-reaching economic repercussions, often detrimental. But in a globalized world of open economies, the tight control of central banks over interest rates is a mirage. Central banks remain important enough players in the loan market that they can push short-term rates up or down a little. But in the final analysis, the market, not central banks, determines real interest rates.
If you take Hummel’s tour, pay attention to the McCloskey-Fama challenge. Also, pay attention to this point:
As the Fed increased bank reserves and currency in circulation by $2.5 trillion over the five years since, it also was, for the first time, paying banks interest on their reserves deposited at the Fed. Although the 0.25 percent rate it pays is quite low, it has consistently exceeded the yield on Treasury bills, one of the primary securities in the Fed’s balance sheet. Thus, at least $2 trillion of the base explosion represents interest-bearing money that, in substance, is government or private debt merely intermediated by the Fed…The Fed can have no more impact on market rates through pure intermediation—borrowing with interest-earning deposits in order to purchase other financial assets—than can Fannie Mae or Freddie Mac. The remaining $500 billion increase in non-interest-bearing money (what economists call “outside money”) represents only a slightly more rapid increase than in the decade before the crisis, and nearly all of that has been in the form of currency in the hands of the public.
In some sense, quantitative easing consists of the Fed borrowing at 0.25 percent to buy Treasury securities. It is engaged in debt management, converting the long-term obligations of the Treasury into short-term obligations of the Fed/Treasury. As other economists have pointed out, the Treasury could cut out the middle man by buying back long-term obligations and borrowing more at the short end of the market.
Hummel does not depart from the standard theoretical assumption that there is an equilibrium “real” money supply, which ultimately ties the price level to the supply of money. That means that when the Fed raises the money supply, eventually the economy must adjust with higher prices. If you take that view, then the question of whether or not the Fed can affect interest rates may not matter. If the Fed can force prices higher, then it can raise nominal GDP, and we have something.
However, I take the view that the McCloskey-Fama challenge means that in fact that the Fed cannot force prices higher, because there is little adjustment needed in the economy when the Fed does something. The Fed is dipping its little cup in and out of a sea of financial assets. Right near the cup, you can observe water move, but viewed from overhead, the sea seems to have its own tides and storms.* As Fischer Black wrote in “Noise,” this leads to the upsetting and heretical conclusion that there is no equilibrium “real” money supply that ties down the price level. Instead, prices evolve higgledy-piggledy, based on habits and expectations.
*If the Fed used a really huge pitcher, big enough to raise the sea level by several meters, then I think we would see an effect. I only think that will happen if we run into a government debt crisis and the option of sudden monetization is adopted.