Everyone loves to dunk on the Federal Reserve (Fed). To many, the setters of U.S. monetary policy never get it right. Its stable of Ph.D. economists are always too late, or too slow, or too early, or too fast. Shockingly, many have built prominent careers in peddling this viewpoint.

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Yet, few realize that the Fed’s errors stem from a poorly constructed view of money that is widely shared, even by its critics. This perspective leads to absurd conclusions like the Fed must destroy demand in order to combat today’s rising prices. Wait, what?!

You heard that right. In fact, you might even be nodding in agreement. The Fed wants to harm the economy to combat today’s rising prices. Its solution for pain is more pain. It’s for our own good, of course.

Well, so, as I mentioned, you can see places where the demand is substantially in excess of supply. And what you’re seeing as a result of that is prices going up and at unsustainable levels, levels that are not consistent with 2 percent inflation. And so what our tools do is that as we raise interest rates, demand moderates: it moves down. … I mean, so, yes, there may be some pain associated with getting back to that.

Jerome Powell, FOMC Press Conference, May 4, 2022

This flawed (and morally repugnant) line of thinking unfortunately dominates macroeconomic discussions today. How: 1) adjusting a single interest rate solely available to commercial banks on a monthly basis predictably impacts the entire country’s economic activity, and; 2) it’s morally proper for the Fed to destroy (certain) people’s lives, is so readily accepted is problematic. Identifying the dangers of such conclusions requires a different view of money; one that illuminates the constructive solution.

Why the Fed was created vs. what it does now

Ever since 1977, the Fed has pursued its so-called Dual Mandate to “maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates” (the third mandate is all but forgotten). This mouthful is popularly interpreted as promoting price stability and maximizing employment. The Fed pursues these goals by adjusting the Fed Funds Rate (FFR) and, more recently, by purchasing select securities in the open market (a.k.a. Quantitative Easing).

Yet, the Fed was established for a wholly different purpose. It was created in 1913 with the Federal Reserve Act to provide liquidity to commercial banks in times of stress via its “Discount Window” (it was also legally tasked to set reserve requirements for the newly created “Reserve Banks”). The U.S. experienced periodic bank panics and runs in the years preceding the Fed’s founding. The Fed was formed to help mitigate the currency demands causing these problems. The Fed’s Discount Window allowed private banks to obtain collateralized loans in order to meet these needs and stay afloat. That’s it; no mention of prices or employment.

More broadly, the Federal Reserve System was established to improve the flow of money and credit throughout the United States in an effort to ensure that banks had the resources to meet the needs of their customers in all parts of the country.

David C. Wheelock, Overview: The History of the Federal Reserve

When you’re a hammer, every problem’s a nail

Thus, the Fed’s current mandate is much different from what it was designed to do. Providing currency to private banks is a wholly different objective than those stipulated by its Dual Mandate. While the Fed’s goals have changed, its tools, however, have not. It can only act in the same three ways—engage in open market operations (OMO), change the discount rate, and adjust reserve requirements. These were designed for the Fed’s original task, not the Dual Mandate.

Today, the Fed acts in order to manipulate the FFR. The FFR is “the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight.” It’s what banks charge each other to borrow overnight funds used to satisfy their various regulatory capital requirements. Only Reserve Bank members have access to these funds.

So, what’s the FFR got to do with stable prices and maximizing employment? If you ask the Fed’s supporters (and critics), it’s complicated. If you ask me, it depends on how you define money. The Fed assumes that changes to the FFR result in a “chain of events” on “a range of economic variables” such that prices for consumer goods and services are impacted. While this view is orthodoxy today, I see it as a rationalization. Congress had a problem to solve and there was the Fed.

Changes in the federal funds rate trigger a chain of events that affect other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and prices of goods and services.

The Federal Reserve