Hasan Comert’s Central Banks and Financial Markets is strong reinforcement for my tendency to be skeptical of the effectiveness of monetary policy. What Comert says is that the evolution of the financial system has tended to decouple monetary aggregates from bank reserves and long-term interest rates from the Fed Funds rate. For example, consider sweep accounts. On p. 33, Comert writes,
Depository institutions developed computer programs to analyze customers’ checkable accounts, which are subject to reserve ratios, and automatically sweep them into savings deposits which were not subject to required reserve ratios.
On p. 47, Comert presents a striking chart showing that the ratio of required reserves to total deposits at depository institutions has declined from about 3.25 percent in 1959 to about 0.25 percent in 2007. At this point, it is perhaps a misnomer to call these “required” reserves. Instead, today there is essentially no connection between the level of reserves that the Fed supplies and the size of the financial sector.
Another way to see the decline in the influence in monetary policy is to track the correlation between the Fed Funds rate and mortgage rates. On p. 145, Comert writes,
the correlation between a one-year mortgage rate and the Fed rate was about 0.700 in the 1990s. It delined to about 0.250 in the period from 2002q1 and 2007q3. On the other hand, whereas the correlations between the 30-year fixed mortgage rate and the Fed rate was about 0.500 in the first period, it is 0.172 for the levels and 0.063 but insignificant for the differences in the second period.
I do not say that the Fed’s monetary dials are completely disconnected. I think that if they were really determined to cause rampant inflation, they could do so. But I do not think that their dials allow for fine tuning. I am not sure that if they were really determined to get an inflation rate of 4 percent, as opposed to 1 percent or 10 percent, that they could do that.
Thank you for your closing comments. I am continually stunned by how many commentators assume that just because a central banker has the tools to move some variable he therefore has the knowledge, tools, and skill to move it to whatever exact target he desires.
Hmm, tried to post this comment before but the blog ate it, posting again:
Velocity has been way overlooked in many precincts. In irrationally exuberant times, like just six years ago, it didn’t matter how much the Fed tightened, speculators were going to bid various commodities up. That’s swung the other way ever since.
Exuberant fiscal policy, as we’ve had since the financial crash, has far more to do with the way things are going than the Fed’s moves, which can be reversed fairly quickly. Yet, people obsess over the Fed.