I always hear Ron Paul and others say that the housing bubble was caused by the Fed's keeping interest rates to historical lows (1%) for such a long time, implying that this caused interest rates to be artificially low, thereby increasing lending and the money supply through fractional reserve banking.
This seems inaccurate because as I understand it the Federal Reserve has no way to set interest rates or even affect them outside of increasing bank reserves and banks rarely increase their reserves by borrowing at the Fed funds interest rate from other banks who have surplus reserves.
Wouldn't it be more accurate to say that it was the Fed's aggressive OMOs that increased bank reserves which in turn lowered interest rates and increased lending?
Any help on this paradox would be appreciated.
reidbump:This seems inaccurate because as I understand it the Federal Reserve has no way to set interest rates or even affect them outside of increasing bank reserves and banks rarely increase their reserves by borrowing at the Fed funds interest rate from other banks who have surplus reserves.
They have the discount window (known as the overnight cash rate in some countries).
More generally though, I think you'll find the answers you're looking for in this recent article here on Mises: http://www.mises.org/story/3040
That article explains how the Fed can attempt to increase the money supply, and in what way those efforts might be thwarted because of the commercial bank's role in the process.
Essentially, the Fed can be instrumental in the creation of money and is often the catalyst, but the commercial banks usually have to come to the party too.
reidbump:Wouldn't it be more accurate to say that it was the Fed's aggressive OMOs that increased bank reserves which in turn lowered interest rates and increased lending?
Well the OMOs are precisely how the Fed achieves it's target interest rates... it's the cash that the Fed injects by buying securities in OMOs which results in additional reserves being available (and thus banks being willing to lend reserves to one another at a lower or higher rate - that being the rate the Fed is targetting)... so this is merely rewording, not more or less accurate.
Perhaps you're talking more about the rates that banks lend to businesses at? Well if the rate that banks can borrow from one another at (or from the Fed at the discount rate) drops, that means banks can loan money to you or I at lower rates, and still retain the same margins... Interest rates for loans made to someone other than the federal government will, of course, also typically incorporate a risk component, and there's very little the central bank can do to affect that portion of the interest charged on loans which exists to cover the risk that the borrower might default... so in that respect you're quite correct, the Fed can't "set" interest rates in the market entirely. It can affect them however.
reidbump: Does the Fed Funds Rate Have A Significant Impact on Interest Rates and the Money Supply?
Yes. The Federal Reserve is in total control. Read my posts on the Compound Interest Paradox and monetizing the debt.
The Federal Reserve directly sets the Fed Funds Rate. They indirectly set long-term interest rates. Suppose the 1 year Treasury bond yield rate is 3%. This means that the expected average Fed Funds Rate over the next year is approximately 3%. If it were different, then there would be an arbitrage opportunity for banks. Banks could borrow at the Fed Funds Rate and buy 1 year Treasuries, or short sell 1 year Treasuries and lend the proceeds at the Fed Funds Rate.
The entire interest rate curve is determined by expected future Federal Reserve policy.
I have my own blog at FSK's Guide to Reality. Let me know if you like it.
jimmy:Essentially, the Fed can be instrumental in the creation of money and is often the catalyst, but the commercial banks usually have to come to the party too.
Absolutely. It is a cartel system nationally with private banks, and then globally between central banks. iirc, Rothbard talks about this in the Case Against the FED. That cartelization is necessary so that inflation can occur as close to lockstep as possible and no banks go rogue and cause disruptions in the process of devaluing the currency.