Why does anyone believe the Fed can control inflation via changes in the Fed Funds “policy rate,” the overnight lending rate that the Fed can control the most.
If this constantly repeated claim were true, it would show up in the data in the form of a close correlation between inflation and the Fed Funds rate. Look at the first graph below.
Graph 1: Low correlation between Fed Funds Rate and CPI since 1983
We do see some co-movement from 1975 until about 1983, and then it stops. It is very difficult to detect even a correlation, never mind causation for the next 40 years. Inflation stays in a range first from roughly 1-5%, then well below 5% all the way from 1990 to 2021, spanning 31 years. Meanwhile the Fed Funds rate hopped up and down with no discernible impact on inflation. Amazingly, from 2009 through most of 2017, the Fed rate was below 1% and for much of the time near 0%. There was virtually no inflation.
Graph 2 paints an even more dramatic picture, albeit using an inflation statistic the Fed started only in the early 1980s.
Graph 2: Low correlation between median CPI and Fed Funds Rate Since origin of series
The general idea behind the claim that the Fed can control inflation via its policy rate seems to be that the Fed raising the policy rate will cause other, more economically meaningful rates, to rise as well. That, in turn, will contract credit and stifle business activity, bringing down inflation because then we will all be poor. As graphs 3 and 4 show, there is not much evidence for this either.
Graph 3 shows the yields on the one-year and 10-year treasuries against the Fed Funds rate. Unsurprisingly the one-year rate tracks the “policy” rate pretty closely, but the more market sensitive 10-year rate does not. From about 1983, the 10-year rate goes into a long-term steady decline with none of the bumpiness of the overnight rate. What this really looks like is the market slowly gaining confidence that inflation has subsided and, therefore, the premium on long-term money could fall as well.
Graph 3: The one-year rate tracks the overnight rate, but the 10-year rate does not.
Graph 4 below gives further confirmation. Both corporate bond yields and the CPI ignore the bumpy blue line of the Fed Funds rate. Instead, the bonds -- far more responsive to the market and business conditions -- cautiously follow inflation downward. The longer inflation stays within the 0-3% range it established in the early 1990s, the more corporate rates fall, a measure of the markets’ confidence that inflation had pretty much gone away.
Graph 4. Neither Corporate Bonds nor the CPI Care What the Fed Does.
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