A Teachable Money Moment
So maybe I’m not completely wasting my time after all; I think we have a teachable moment here.
Let me offer a stylized description of the role of the Fed. Think of it as choosing a point on a downward-sloping demand curve for monetary base, the sum of bank reserves and currency in circulation. And yes, that is what the Fed does; its power comes from the fact that the Fed, and only the Fed, can add to or subtract from that stock of monetary base. So the picture looks like this, with the downward-sloping line representing the demand for base, and A representing the point the Fed chooses:
Now how, as an operational matter, does the Fed get to A? It could set the level of monetary base, and let the interest rate pop out as a result, or it could set the interest rate, and let the base pop out. In practice, these days — but not always in the past — it sets the rate: the FOMC tells the open-market desk in New York to hit a target rate.
Why do it that way? Well, that demand curve fluctuates over time, and the Fed has decided that on a day-to-day or week-to-week basis it would rather see the base move around than the interest rate bounce up and down. But that’s a narrow, technical issue. At a basic level it doesn’t really matter: in the end, the Fed can use either technique to choose any point it wants on that curve.
And which point on that curve it chooses has large implications for the economy as a whole. In particular, the Fed can always choke off a private-sector credit boom by moving up and to the left.
That’s the bottom line: the Fed controls credit conditions, except when we’re in a liquidity trap and it’s pushing on a string. Everything else — all the talk about banks creating money, and yes, all the gotchas my critics think they’ve found in what I’m saying — is irrelevant to the actual economic discussion. And it’s really, really a waste of time to obsess over the fact that the Fed currently gets to point A by choosing r* instead of B*.
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