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My post on the eurozone crisis and Ben Bernanke targeting of the Fed Funds rate has resulted in a number of commenters asking for specifics on how it’s all done. Below is a quick explanation, for a more detailed explanation I recommend Murray Rothbard’s book, The Mystery of Banking.
The Federal Reserve manipulates interest rates, generally, by buying and selling Treasury bills. When they buy Treasury bills, they add reserves to the banking system. That is they issue a credit to the bank (primary dealer) that they buy the T-bills from. If the bank doesn’t put the credit into excess reserves, the money becomes part of required reserves that the bank lends money out against, which increases the money supply. (The increase in money supply is actually a multiple of the added required reserves see Rothbard)
When the Federal Reserve sells Treasury bills, the bank (primary dealer) that they sell the T-bills to pays for them with reserves, which drains reserves from the system and decreases the amount of money in the system.
Generally, when the Fed is targeting interest rates, it is doing so to keep interest rates from climbing. This is what occurred during the G. William Miller period I discussed in my earlier post.
During the Miller period, the Fed had to buy huge amounts of Treasury bills to keep rates down. This resulted in a huge increase in reserves, which resulted in exploding money supply, which resulted in soaring prices. Which resulted in higher interest rates. It was a tiger by the tail situation. When Volcker replaced Miller at the Fed, he stopped targeting interest rates and said that instead he would just slow money supply growth (to battle the price inflation)and not care about interest rates. (Rates then soared to double digit levels, some reaching 20% plus, but Volcker was successful in killing the price inflation)
At present, on a very short term basis, Bernanke appears to be targeting the key Fed funds rate at 0.15%. Because there is huge hot money flowing into the U.S. from the eurozone, the Fed has to drain reserves to keep the Fed funds rate at 0.15%. Otherwise the rate would likely drop lower. BUT, once the hot money flow stops (and possibly reverses) the pressure on rates is going to be to the upside. If the Fed keeps its target at 0.15% for Fed funds, this means they will have to buy Treasury bills to keep the Fed funds rate from climbing higher. Thus, the Fed will be reversing from the draining of reserves to the adding of reserves. And the adding of reserves will likely mean climbing money supply.
Bottom line: A roller coaster economy brought to you by Ben Bernanke by his first draining reserves and his then expanding them is the path we are on.
Reprinted with permission from Economic Policy Journal.