How Monetary Policy Works

Ben Bernanke gave a very nice tutorial on monetary policy to an education symposium in Ohio yesterday.  The material will probably be a bit elementary for veteran students of the Fed, but I think you will find it worthwhile if you are not in that group.  At a minimum, it is worth emphasizing (again and again) this often misunderstood point:

The person in the street might tell you that the Fed "controls interest rates." That statement is not literally accurate. In fact, the Fed has little or no direct influence over the interest rates that matter most for the economy, such as mortgage rates, corporate bond rates, or the rates on Treasury securities. Instead, the Fed affects these key rates, as well as the prices of financial assets such as stocks, only indirectly...

The Fed controls very short-term interest rates quite effectively, but the long-term rates that really matter for the economy depend not on the current short-term rate but on the whole trajectory of future short-term rates expected by market participants. Thus, to affect long-term rates, the FOMC must somehow signal to the financial markets its plans for setting future short-term rates.

I would add to that the observation that those trajectories also depend on things quite beyond the control of the central bank -- like real, long-term returns to capital.  These are lessons worth remembering as we watch the path interest rates unfold over the immediate future.