Central Bank Control Over Interest Rates: The Myth and the Reality
40 Pages Posted: 3 Oct 2017 Last revised: 10 May 2018
Date Written: August 1, 2017
Many believe that central banks, such as the Federal Reserve (Fed), have almost total control over some critical interest rates. Serious monetary economists are more sophisticated. They realize that central bank control over interest rates is very far from complete. Nonetheless, central bank officials and many economists are largely responsible for the popular misapprehension. This is because they persistently and misleadingly describe central bank policy as if it determined interest rates. Their focus on interest rates as both the target and indicator of monetary policy stems from the fact that even those holding the sophisticated view of how monetary policy works tend to overestimate the strength and significance of a central bank’s limited effect on real interest rates. There is no denying that central banks have some impacts on interest rates, in both the short run and the long run. However, this working paper argues that not only is the popular belief in precise central bank management of interest rates simply wrong, but also even the sophisticated view of central bankers and mainstream monetary economists turns out to be overstated. In fact, continued targeting of interest rates by central banks has even led to some confusion and policy errors.
Keywords: interest rates, nominal interest rates, real interest rates, Fisher effect, Taylor rule, central bank, Federal Reserve, monetary policy, interest on reserves, federal funds rate, monetary target, history of economic thought
JEL Classification: E43, E52, E58, B1, B22
Suggested Citation: Suggested Citation