In a recent dialogue between economic analysts George Gammon and Jeff Snider, the prevailing belief in the Federal Reserve’s control over interest rates and banking liquidity was rigorously examined. The consensus? This control may be more perception than reality, especially when reflecting on historical data from 1980 to 2007.
Federal Reserve’s Perceived Control
For decades, textbooks and financial lore have perpetuated the narrative that the Federal Reserve (the Fed) manages the U.S. economy’s monetary conditions by manipulating the federal funds rate through open market operations. This perception has been questioned by Gammon and Snider, who argue that the Fed’s influence over the economy, and specifically liquidity, is not as direct or effective as many believe.
During the period from 1980 to 2007, despite significant fluctuations in M2 money supply and notable decreases in interest rates, the actual reserves held by banks at the Fed remained relatively flat. This lack of correlation challenges the textbook explanation of the Fed’s interest rate management, suggesting an alternative mechanism at play.
The Reality of Liquidity and Interest Rates
Snider points to “moral suasion,” an informal term describing the Fed’s reliance on the banking system’s cooperation rather than direct control via open market operations. In essence, the Fed suggests interest rate targets, and banks, typically in agreement with the Fed’s assessment, adjust accordingly.
This symbiotic relationship implies that banks have the ability to create liquidity independently of the Fed, a process that has functioned without significant reserves. Snider asserts that the liquidity necessary for the vast sums in the banking system is generated through credit creation among banks themselves.
The Post-2008 Era and Quantitative Easing
The conversation then shifted to the post-2008 landscape, where quantitative easing led to an abundance of reserves. Here, the Fed’s role seemed to have expanded with the implementation of tools like interest on excess reserves (IOER) and the overnight reverse repurchase agreement (ON RRP). Yet, Snider and Gammon argue that even with these tools, the fundamental dynamics have not shifted—interest rates at the long end of the curve remain largely independent of the Fed’s actions.
Yield Curve Inversions and Economic Signals
A key focus of the discussion was the yield curve inversion, a phenomenon where long-term rates fall below short-term rates, historically a precursor to economic downturns. The market’s independent behavior during such inversions underscores the limited scope of the Fed’s influence. Snider emphasized that the inversion signifies the market’s assessment of future economic conditions, not the Fed’s policy decisions.
Conclusion: Fed’s Role as a Market Participant, Not Controller
In conclusion, the conversation between Gammon and Snider sheds light on a complex financial system where the Fed participates but does not dictate outcomes. Market dynamics, risk assessments, and growth expectations play significant roles in determining liquidity and interest rates. As the discussion highlighted, understanding these nuanced interactions is crucial for a realistic perspective on the Fed’s true impact on the economy.