This week, Dr. Roy Cordato wrote a research brief for the John Locke Foundation on the Federal Reserve. In it, Dr. Cordato explains the Federal Reserve plays a central role in the economy – namely setting the Federal Funds rate and the discount rate. Cordato explains:
[T]he Federal Funds Rate (the rate at which banks can lend to each other) or the discount rate (the rate at which banks can borrow from the Fed) that have a powerful influence on most other interest rates and certainly move those interest rates in one direction or another.
Dr. Cordato argues that the Federal Reserve’s setting and changing of these rates constitutes a kind of price manipulation that distorts the market. He explains:
Depending on the nature of price manipulation, they can cause shortages and surpluses. Rent control can cause blighted housing. And in the labor markets, minimum wage laws cause unemployment. Centralized price manipulation will necessarily shift investments and production decisions from areas that are most consistent with consumer desires to areas that the market would not support otherwise.
Allowing the laws of supply and demand to set interest rates, rather than the Fed, Cordato argues would be more efficient:
Freely determined interest rates perform an important role in coordinating people’s plans. When people are saving more, it means that they want to purchase more goods and services in the relatively distant future. This increased savings reduces interest rates, which makes borrowing on the part of entrepreneurs and businesses cheaper. What this means is that it makes longer-term investments, that is, investments that will produce goods and services further into the future more profitable and more future goods will be produced. The interest rate is performing the important function of coordinating the preferences of consumers with the plans of producers through time. It is part of the marvel of how free markets work and create orderly production decisions that are consistent with people’s preferences.
No matter how informed the Federal Reserve is, it cannot possibly know the future (or even the present) demands in every citizen’s head. For this reason, Cordato suggests the Fed cannot set the price of borrowing money any better than it can set the price for cereal. Cordato writes:
If the Fed could know the right price for loanable funds, then there is no reason to think that they couldn’t also know the correct price for shoes, computers, or food. It is the fact that neither the Fed nor any other central authority can know the right price for any of these products, interest rates included, which makes efficient socialist central planning impossible.