What is the reasoning behind having the Fed, rather than the market, set short term interest rates?

BY busadmin  November 7, 2008 at 10:02 AM EST

Fed Chairman Ben Bernanke; AP photo

Question/Comment: Dear Mr. Solman: I’m hoping you will answer my question as to the reasoning behind or justification for having a committee (i.e., the Federal Reserve) setting the price of money, i.e., interest rate. It is generally accepted that it is beyond the ability of any central planning committee to set the price of apples or other commodities, because market conditions change too rapidly. Which makes me wonder, what is the reasoning behind having the Fed, rather than the market, set short term interest rates?

Paul Solman: I assume you don’t mean to distinguish between “committee” and one-person planning, Mr. Freudmann. Your point is central planning vs. market pricing. And it’s a good foil for explaining the assumptions under which a market does the pricing job ideally – that is, allocating resources where they’re supposedly most wanted, including money, which is allocated by ITS price: the interest rate.

The assumptions of perfect market competition include these: no externalities (side effects not included in the price, like pollution); no “asymmetrical information” (meaning everyone has equal access to all relevant information, which is often not true); rational decision-making (so often a caricature when it comes to us humans); no one buyer or seller having any control over pricing (simply not true in so many cases, from sellers like the drug companies to buyers like the government).

Moreover, a market takes as given the distribution of wealth. Thus, if the Saudis, say, had amassed 99 percent of the globe’s wealth and the other six plus billion of us owned the remaining one percent, the market economy would presumably price shemaghs (you could look it up) much more highly than if the Saudis were as poor as, for instance, the Sudanese. In other words, even if the market were “perfect,” it is still deeply influenced by the initial conditions of its participants.

Given all these caveats, most American economists would say the Fed has a role in setting interest rates. The side effects of interest rates responding solely to market conditions might be undesirable, stifling the economy when it needs stimulus, for example, or goosing it when it’s already in a bubble.

That said, the market DOES have a major impact on rates. And it’s also fair to say the Fed, by running a loose monetary policy in the early 2000s (i.e., low interest rates), may well have set us up this fall.