Kenneth Rogoff of Harvard University was recently interviewed on NPR’s Marketplace and seemed to claim that the Fed can cut rates without printing money. I was under the impression that the only way they could cut interest rates was by printing. Can anyone explain how this works?
Here’s an excerpt of the interview:
Rogoff: They’re going to cut more. They’re not done. I think we’re going to end up down at zero. But they don’t really want to get there, because they don’t know what they’ll do next. After it’s at zero.
Ryssdal: Down at zero percent?
Rogoff: I think it’s very likely that we’re going to see that. Things are that difficult in the credit market. It’s a mess. They’re having to take other measures to try to pump up liquidity in the economy.
Ryssdal: Once you get to zero percent, then, what do you do if you need more rate cutting.
Rogoff:Well, you can’t cut rates, but you can print money, basically, and drive up inflation that way. And that’s really what it does. And even though that doesn’t cut the interest rate – you can’t go below zero – in some sense, it makes it even cheaper to borrow, because you can pay back later with money that’s worth less. So it is possible, in a sense, to still cut the rate that’s relevant to investors. We call it the “real interest rate.” And Ben Bernanke’s talked about that. Even before he became Fed governor, he criticized Japan for not doing it. Now the ball’s in his court.
Mr. Rogoff is correct; the Fed can and has created money without cutting federal funds target rate. Traditionally, the primary method that the Fed used to create money was cutting the federal funds target rate. However, they can also change the interest rate charged at the discount window or change the reserve requirement. Furthermore, they can back money creation with something other than government securities, such as mortgage securities. None of these actions will change the federal funds target rate but they will all change the money supply.
I posted a more complete explanation of how this works in this forum about a year ago but it seems to have been removed.
That’s more or less correct. The Fed can’t just enter a Fed Funds rate and immediately have that be the rate, which is why call it “target rate”. If they lower the rate 50 basis points they will do something along the lines of buying “x amount of Treasury securities to get to y% rate”. When the Fed buys these securities or as somebody else correctly stated, uses mortgage securities or pretty much whatever they please, they’re holding more things from which to expand money/credit from. If the Fed wants to raise the target rate they sell securities which usually means they will need higher reserve requirements (at least they should) and makes the Fed funds rate go higher.
I understand the rate of inflation in the U.S, is about 5%. Shouldn’t the interest rate instead be INCREASED to something like 6% or beyond? So that real interest rates are positive and money is actually worth something?
Rogoff isn’t saying that you can cut interest rates without printing money, he is saying that you can print money without cutting interest rates. For example, the Fed could buy a lot of securities, releasing money onto the market. Or it could engage in more bailouts. Or it could do the so-called “helicopter drop.”
No, it can sell securities, therefore taking money from credit markets, and thus create deflation. Usually, the Fed will engage in both buying and selling securities, but it’ll usually buy more than sell, thus creating inflation. They can also raise the discount rate beyond the point that banks are willing to borrow from them, thus creating deflation.
Austrian economics emphasizes the role of savings in order to encourage economic growth. An interest rate higher than the rate of inflation will encourage savings, no further borrowing which is what started this excess credit mess.
‘Encourage’ is the wrong word to use here. Austrian Economics merely points out that increased savings now will lead to economic growth.
However, Austrian Economics also teaches us that when the fed manipulates interest rates they cause misallocations of capital which leads to the boom/bust business cycles. The solution is to get rid of the Federal Reserve banking cartel so interest rates are allowed to freely move to reflect the real underlying time preferences of people in society. Then, if people want consumption now they can consume and if they want it later they can save.