Back to basics: How does the Fed "set" short and long term interest rates?
Prof. DeLong continues his public service and posts a
discussion of how the Fed does its work. I think people tend to believe the Fed sets interest rates directly, as if by fiat. However, the Fed doesn't just declare what interest rates are. They participate in markets to help adjust short term rates (e.g. those rates of very short-term loans between banks). In these few markets, the Fed has a direct and large impact on the price (i.e. the short-term interest rates).
Indirectly, these activities in short-term markets impact longer term interest rates. You can think of long-term interest rates as having two components: the cost of risk and the cost of short term rates. There is risk to lending money for a long term. With more time, the borrower is more likely to default (i.e. not pay the loan back) so the bank charges a premium for these types of loans. For the second component, you can think of the short term component of a long-term interest rate as the bank's cost of the loan. Instead of lending out the money, they could keep investing in short-term investments. It's easy to see how the Fed's activities in the short-term markets impacts this second component.
If it appears that the Fed will undertake activities that will increase (decrease) short-term interest rates then banks will begin to charge more (less) for loans. The Fed helps to set these expectations by having a continuous and transparent dialogue with the public. This is why you always see statements from the Fed or you read about Chairman Greenspan testifying before Congress. The Fed is trying to signal how it will be adjusting short-term interest rates.
Question: Why doesn't the Fed just tell us what it thinks the rates will be for the next year or so? Why the signaling and not just objective targets?
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