Visualizing what the Fed does. Photographer: Jeff Speed/First Light via Getty Images
Visualizing what the Fed does. Photographer: Jeff Speed/First Light via Getty Images

We’ve been hearing a lot about “artificially low” interest rates these days. But what does that mean?

Paul Krugman blogged about this the other day, and had this to say:

Although I hear the phrase “artificially low” all the time, I don’t think many people who use it have thought through what they mean. What would a non-artificial interest rate be? ...

Well, we do know ... what an unnatural rate ... would be: it would be an interest rate set too low in the sense that the economy overheats and we have accelerating inflation. But that hasn’t been happening; yes, there’s a slight uptick in some U.S. inflation measures, but nothing out there that suggests an interest rate that is way too low in this macroeconomic sense.

Some people, though, aren’t ready to accept this definition. On Twitter, I’ve heard several people say that interest rates are “artificial” if the Fed, rather than the market, sets them. But by this criterion, interest rates are always artificial. The Fed controls the supply of federal funds, which are a good over which the Fed has a monopoly. Because only the Fed can create or destroy federal funds, the Fed sets the interest rate on those funds -- so the Fed always sets the federal funds rate. By this standard, interest rates are always artificial.

Of course, the Fed’s control isn't absolute. It’s very difficult for the Fed to set the funds rate below zero. So because the rate is now very near zero, it’s actually less under the Fed’s control now than under normal circumstances. Does that make interest rates less “artificial” now? Maybe.

Also, remember that the federal funds rate is only one interest rate among many. This rate exerts some influence over other interest rates, since different kinds of bonds are partial substitutes for each other. But in recent times, this correlation has broken down somewhat. The Fed has lowered the federal funds rate as much as it can, but other interest rates, on things such as corporate bonds and mortgages, haven’t declined that much. Does that mean that interest rates are less “artificial” now? Maybe.

On Twitter, a few people suggested a third definition of “artificial.” When the monetary base (i.e. the supply of federal funds) is constant, they told me, then the interest rate is at its “natural” level, because if the monetary base is unchanging, then the Fed isn't doing anything to affect the federal funds rate.

This is just plain wrong. Suppose your local utility (which we’ll assume is a monopoly) says that it will only sell your town 1 gigawatt of power -- no more, no less. I guarantee you that decision will have an effect on the price of electricity. In the same way, holding the monetary base constant has an effect on the interest rate.

But this misconception gives a clue to why people think interest rates are currently “artificial.” If the Fed held the monetary base constant, it would be doing something, but it would look like it was doing nothing -- just like when I hold my hand still in a blowing wind, it looks like I’m doing nothing even though I’m actually opposing the wind. In normal times, when the federal funds rate is something other than zero, the Fed looks like it’s doing a bunch of routine, boring things known as open-market operations.

But right now, with interest rates near zero, the Fed has to do extraordinary, unusual things -- quantitative easing -- in order to change the money supply. Every decision is unprecedented and unique and newsworthy. That makes it look like the Fed is very active, as if it’s doing a lot of stuff to keep interest rates low.

In other words, I think that there may be an illusion at work here. Even though the Fed is less in control of interest rates than usual, the novelty of its actions makes it look like it’s intervening more in markets. Thus, interest rates look “artificial” because of QE. This illusion of artificiality is enhanced by the fact that interest rates, historically speaking, are usually not this low for this long.

But the fact remains: As long as we have a fiat money system and a central bank, the Fed will exert an influence over interest rates. Unless you think the government should get out of the money-creating business -- that we should switch to a system where independent banks, or individuals, create their own private currencies -- then you have to accept that interest rates, especially safe rates, are always going to be artificial in some sense.

To contact the author of this article: Noah Smith at noahsmith.bloomberg@gmail.com.

To contact the editor responsible for this article: James Greiff at jgreiff@bloomberg.net.