Rand Paul Has No Idea How The Fed Works

Sorry for the blunt title, but I couldn’t think of anything more appropriate….

I was watching the Republican debate this evening when Rand Paul made the following comments on the Federal Reserve in response to rising income inequality:

“By artificially keeping interest rates below the market rate average ordinary citizens have a tough time earning interest and a tough time making money.  They’re actually talking now about negative interest rates.

…The money, as it’s created, through QE or by other means, tends to start out at the big banks in New York.  And because we’re now paying interest for them to keep the money there the money doesn’t filter out into the rest of the economy.

…We also find that as the Federal Reserve destroys the value of the currency what you’re finding is that, if you’re poor, if you make $20,000 a year and you have 3 or 4 kids and you’re trying to get by, as your prices rise and the value of the dollar shrinks, these are the people who are hurt the worst.”

Okay, that’s all very wrong.  But first we should note that Rand Paul belongs to the so-called Austrian Economics school, a school that has been so fantastically wrong about everything since 2008 (inflation, rising rates, government debt problems, etc) that it is amazing anyone still has the guts to say they believe in the many myths and fallacies promoted by this “school”.  But let’s touch on each point above because Paul’s misunderstandings make for a good learning moment:

Myth: Interest rates are “artificially low” and low interest rates cause income inequality.

Reality: The Fed has not kept interest rates artificially low. Interest rates are low because the economy is weak.  

People sometimes talk about the Fed as if it controls the entire economy. No, the Fed sets overnight interest rates by responding to economic growth.  More importantly, the Fed only controls the overnight rate.  It does not set the entire term structure of interest rates across the economy. And as I’ve explained before, the natural rate of interest on overnight loans is 0% because a banking system with excess reserves will push the overnight rate to 0% as banks try to lend their reserves. In other words, the Fed always has to manipulate the overnight rate UP, not down. But this is a function of the Fed’s perception of economic growth. With very weak growth and virtually no inflation the Fed has responded by keeping rates low.  Interest rates aren’t “artificially low”, the economy is fundamentally weak.