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It is so long since the long-term interest rate market was free of Fed intervention that the meaning of freedom has become deeply blurred. Many commentators suggest that the much talked about multi-year program designed by the Yellen-Fischer Fed to reduce that institution’s balance sheet is in fact synonymous with the road back to freedom for long-term rates. That is just not so.

And no candidate apparently on the Trump short list for all those empty or soon to be empty seats on the Fed board (including the chair and vice-chair) is advocating an alternative normalization course which would truly liberate the long-term rate market. Instead, all would continue to pursue monetary policy by promoting expectations regarding the path of short-term rates; in turn, these strongly influence long-term rates. The promotion might involve more use of the Taylor rule and less discretionary judgment about the economic situation. Application of this rule, though, requires crucially the input of an estimate for the neutral interest rate and for the natural unemployment rate alongside an inflation target.

Rate-Setting in an Unhampered Market

The determination of long-term interest rates in a free market requires none of that. Instead the long-term rate would be set by the totality of individual decisions, based on highly heterogeneous attitudes and decentralized knowledge, about how to spread consumption over time and investment opportunity. Long-term rates determined from bottom up in this way are a key feature of a sound money regime. The alternative of long-term rates being heavily influenced by monetary bureaucrats plotting an optimal path for short-term rates is typical of unsound money with its inherent susceptibility to inflation (both goods and assets).

Indeed, freedom in the long-term rate market is bolstered by volatility and unpredictability of short-term rates and is smothered by the opposites. Under the pre-World-War-One gold standard short-term rates reflected passing surpluses and deficits of funds in the high-powered money market and violent fluctuations occurred (though not continuously). No one had the least idea what the average short-term rate would be over any given time interval. Investors and borrowers in the long-term rate markets did not take their cue from the short-term rate market.

Constant Fed Meddling in Interest Rates

Ever since the Fed opened its doors in November 1914, it has been very different (except for two sub-periods detailed below).

The Fed has set the discount rate or overnight rate, with changes made often amidst much fanfare. Participants in the long-term rate markets have sought to divine official intentions regarding the time-path for the short-term rate — which has been a main policy tool. Central bankers do not change their policy rates on a dime and like to project “consistency and continuity.” The Benjamin Strong Fed led the way by steering short-term rates at low levels despite economic boom (lulled into complacency by “no inflation” and out of intermittent concern to help Bank of England governor Norman stabilize the pound). The result was a remarkably low level of long-term rates which spawned a vast carry trade during the years 1924–28 into high-yielding German credit which later burst with such fateful consequences.

All the new Federal Reserve “transparency” of recent years — including regular press conferences — is a way of increasing commitment to a time-path for short-term rates and so strengthening official influence over long-term rate markets. This is in sharp contrast to the brief monetarist experiment of 1979–82 when the Fed renounced the pegging of short-term rates and these became hugely volatile within the context of an operating policy of which the highlight was slowing the growth of the monetary base.

In fact, during the preceding decade (say from the mid-1960s) the Fed’s power to influence long-term rates had been at a low ebb as there was such low confidence in that institution achieving its stated objectives. In the aftermath of the monetarist experiment confidence in the Fed was at a high ebb. Even so, the degree of official influence over long-term rates was much less that what we have seen under the Greenspan Fed especially from the early 2000s.

Fast forward to the present. Interest rate markets are today transfixed by each word of Fed policymakers. Yes, it is possible that there will be revulsion at some stage as investors lose confidence in the central bank and its views even become a subject of ridicule. But that is not the present situation. Present and aspiring Fed officials say that glacial balance sheet reduction will free long-term rates. That is doubtful.

One claim is that a growing stock of long-maturity bonds to be held by investors will cause the so-called term risk premium to rise from present low or even negative levels. But there are already huge stocks of such paper outside the Fed. Tiny or negative term risk premiums have stemmed from a hunt for yield unleashed by the Great Monetary Experiment. Yes, a normalization of monetary conditions would cause the hunt for yield to fade and a substantial and variable term risk premium would return, but that involves more than shrinking the Fed balance sheet.

What Real Normalization Would Look Like

Genuine normalization would involve putting monetary base back at the pivot of the monetary system and abandoning the 2% inflation standard. Crucially monetary base must again become non-interest bearing. It is the attempt of holders of high-powered money in its various forms (cash, reserves) to economize on this as rates rise which powers the dynamics of interest rate determination in a free money market where the central bank is not pegging the rate.

A program to put monetary base back at the pivot and free the long-term rate could take place in one big bang.

The Fed would swap its holdings of bonds with the Treasury, obtaining bills in exchange and sell these in open market operations to shrink the monetary base. The Fed would formulate targets for growth in the base consistent with a very long-run tendency for prices of goods and services to revert to the mean. Success here would depend on the demand for monetary base being steadied and deepened. Curtailing the lender of last resort function and deposit insurance and ending the war on cash would contribute to that aim. Yes, short-term rates might go through spells of volatility. But that would sustain freedom in the long-term rate market.